4/16/2018

NE 364
Engineering Economy
Lecture 7
Money-Time Relationships and Equivalence
(Part 5: Nominal and Effective Interest Rates)

NE 364 Engineering Economy

Annual Compounding
January
February
March
April
May
June
July
August
September
October
November Compounding
December
January
February
NE 364 Engineering Economy
March

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January
Very often the interest
February
period, or time
March
between successive
compounding, is less April

than one year May Compounding

June
(e.g., daily, weekly, July
monthly, or quarterly). August
September
October
November Compounding
December
January
February
NE 364 Engineering Economy

Example 1
 if the interest rate is 6% per interest period
 and the interest period is six months,
 it is customary to speak of this rate as
 "12% compounded semiannually.”
 Here the annual rate of interest is known as the nominal
rate, 12% in this case. A nominal interest rate is represented
by r.
 But the actual (or effective) annual rate i on the principal is
not 12%, but something greater, because compounding
occurs twice during the year.

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Solution

$1000
compounded at a
semiannual
frequency (r=12%)

NE 364 Engineering Economy

$1000
compounded at a
monthly frequency
(r=12%)

The more frequent the compounding the

greater the effective interest.
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Effective Interest Rate

Let
r be the nominal, annual interest rate and
M the number of compounding periods per year.
We can find, ie, the effective interest by using the
formula below.

NE 364 Engineering Economy

Examples
For an 18% nominal rate, compounded quarterly, the
effective interest is.

For a 7% nominal rate, compounded monthly, the

effective interest is.

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Example 2
A credit card company charges an interest rate of 1.375%
per month on the unpaid balance of all accounts. The
interest rate, they claim, is 12(1.375%)=16.5%. What is
the effective rate of interest per year being charged by the
company?

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Example 3
Suppose that a $100 lump-sum amount is invested for 10
years at a nominal interest rate of 6% compounded
quarterly. How much is it worth at the end of the 10th
year?

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Example 4
 How much money will be in an account in 5 years if
$10,000 is deposited now with interest rate of:
 1% per month.
 12% compounded monthly.

NE 364 Engineering Economy

Solution
(a) For monthly rate, 1% is effective [n = (5 years)×(12
Compunding Periods per year = 60]
F = 10,000(F/P,1%,60) =
months
$18,167 effective i per
i and n must always
have same time units
month
(b) For an annual rate, effective i/year = (1 +
0.12/12)12 –1 = 12.683%
F = 10,000(F/P,12.683%,5)
years
= $18,167 effective i per year
i and n must always
have same time units

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Equivalence relations involving

annual uniform series
 Recall:
 Payment Period – Length of time between cash flows
 Compounding Period – Shortest time unit over which
interest is charged or earned

NE 364 Engineering Economy

Example 5
A loan of $15,000 requires monthly payments of $477
over a 36-month period of time. These payments include
both principal and interest.

a) What is the nominal interest rate (APR) for this loan?

b) What is the effective interest rate per year?
c) Determine the amount of unpaid loan principal after 20
months.

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Example 6
Stan Moneymaker has a bank loan for $10,000 to pay for
his new truck. This loan is to be repaid in equal end-of-
month installments for five years with a nominal interest
rate of 12% compounded monthly. What is the amount of
each payment?

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Equivalence relations involving

annual uniform series
Payment period

≥ Compounding period < compounding period

Steps:
Inter-period cash flows earn NO
1. Find effective i per payment period
interest. Actual cash flow diagram is
2. determine n, the number of A
changed.
values involved
Example: quarterly payments for 6
years yields n = 4×6 = 24

NE 364 Engineering Economy

Example 7
 How much money will be accumulated in 10 years from
a deposit of $500 every year if the interest rate is 0.5%
per month?

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 First, find relationship between PP and CP

 Payment period = one year, Compounding period = one month;

PP > CP
Step 1: i /year= (1 + 0.06/12)12 – 1 = 6.17%

Step 2: n = 10(1) = 10 annual periods

F = 500(F/A,6.17%,10) = $6,643.25

NE 364 Engineering Economy

Example 8
 A person deposits $100 per month into a savings account for 2
years.

 Construct the cash flow diagram to determine how much will be in

the account after 2 years at i = 6% per year, compounded
annually. Assume there is no inter-period interest.
F=?
F=?

0 1 2 3 4 5 6 7 8 9 10 23 24 Months
years
0
100

100×12=1200 100×12= 1200

i=6% per year
F= 1200(F/A, 6%, 2)=1200×2.06=$2,472

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