ENGINEERING ECONOMY - Nomınal - and - Effective - Interest
ENGINEERING ECONOMY - Nomınal - and - Effective - Interest
ENGINEERING ECONOMY - Nomınal - and - Effective - Interest
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LEARNING OUTCOMES
1. Understand interest rate statements
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Interest Rate Statements
The terms ‘nominal’ and ‘effective’ enter into consideration
when the interest period is less than one year.
Interest period (t) – period of time over which interest is expressed. For example,
1% per month.
Compounding period (CP) – Shortest time unit over which interest is charged or earned.
For example,10% per year compounded monthly.
Compounding frequency (m) – Number of times compounding occurs within the interest
period t. For example, at i = 10% per year, compounded
monthly, interest would be compounded 12 times during
the one year interest period.
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Understanding Interest Rate Terminology
A nominal interest rate (r) is obtained by multiplying an interest rate that is
expressed over a short time period by the number of compounding periods in a
longer time period: That is:
r = interest rate per period x number of compounding periods
Effective interest rates (i) take compounding into account (effective rates can
be obtained from nominal rates via a formula to be discussed later).
IMPORTANT: Nominal interest rates are essentially simple interest rates. Therefore,
they can never be used in interest formulas.
Effective rates must always be used hereafter in all interest formulas.
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More About Interest Rate Terminology
There are 3 general ways to express interest rates as shown below
(2) i = 10% per year, comp’d semiannually When compounding period is given
i = 3% per quarter, comp’d monthly and it is not the same as interest
period, it is nominal
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Effective Annual Interest Rates (1)
Nominal rates are converted into effective annual rates via the equation:
𝐢𝐚 = 𝟏 + 𝐢 𝐦 −𝟏
where ia = effective annual interest rate
i = effective rate for one compounding period
m = number times interest is compounded per year
Example: For a nominal interest rate of 12% per year, determine the nominal
and effective rates per year for (a) quarterly, and (b) monthly compounding
Nominal rates can be converted into effective rates for any time period
via the following equation:
𝐢 = 𝟏 + 𝐫/𝐦 𝐦 −𝟏
where i = effective interest rate for any time period
r = nominal rate for same time period as i
m = no. times interest is comp’d in period specified for i
Spreadsheet function is = EFFECT(r%,m) where r = nominal rate per period specified for i
Example: For an interest rate of 1.2% per month, determine the nominal and
effective rates (a) per quarter, and (b) per year
Similarly, for the diagram below, the CP is quarterly and the payment period (PP) is semiannual
F=?
i = 10% per year, compounded quarterly
0 1 2 3 4 5 Years
0 1 2 3 4 5 6 7 8
Semi-annual periods
A = $8000
Semi-annual PP
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Single Amounts with PP > CP
For problems involving single amounts, the payment period (PP) is usually longer
than the compounding period (CP). For these problems, there are an infinite
number of i and n combinations that can be used, with only two restrictions:
Method 1: Determine effective interest rate over the compounding period CP, and
set n equal to the number of compounding periods between P and F
Method 2: Determine the effective interest rate for any time period t, and
set n equal to the total number of those same time periods.
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Example: Single Amounts with PP ≥ CP
How much money will be in an account in 5 years if $10,000 is deposited
now at an interest rate of 1% per month? Use three different interest
rates: (a) monthly, (b) quarterly , and (c) yearly.
(a) For monthly rate, 1% is effective [n = (5 years) × (12 CP per year = 60]
F = 10,000(F/P,1%,60) = $18,167
months i and n must always
effective i per month have same time units
When PP ≥ CP, the only procedure (2 steps) that can be used is as follows:
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Example: Series with PP ≥ CP
How much money will be accumulated in 10 years from a deposit
of $500 every 6 months if the interest rate is 1% per month?
Note: The condition of PP < CP with no interperiod interest is the only situation
in which the actual cash flow diagram is changed
For policy (2), cash flows are not moved and equivalent P, F, and A values are
determined using the effective interest rate per payment period
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Example: Series with PP < CP
A person deposits $100 per month into a savings account for 2 years. If
$75 is withdrawn in months 5, 7 and 8 (in addition to the deposits),
construct the cash flow diagram to determine how much will be in the
account after 2 years at i = 6% per year, compounded quarterly. Assume
there is no interperiod interest.
Solution: Since PP < CP with no interperiod interest, the cash flow diagram must be
changed using quarters as the time periods
F=?
F=? 75 150
75 75 75
from to 0 1 2 3 4 5 6 7 8 9 10 21 24 Months
0 1 2 3 4 5 6 7 8 9 10 23 24
this this 1 2 3 7 8 Quarters
100 300 300 300 300 300
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Continuous Compounding
When the interest period is infinitely small, interest is
compounded continuously. Therefore, PP > CP and m increases.
Example: Find the present worth of $2500 deposits in years 1 through 8 if the
interest rate is 7% per year for the first five years and 10% per year thereafter.
An equivalent annual worth value can be obtained by replacing each cash flow
amount with ‘A’ and setting the equation equal to the calculated P value
Interest rates are stated different ways; must know how to get effective rates
For single amounts, make sure units on i and n are the same
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Summary of Important Points (2)
For varying rates, use stated i values for respective time periods
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