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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
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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
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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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