Nominal and Effective Interests Statements

So far we know simple and compound interest; compound interest

includes interest on the interest earned in the previous period
When interest is compounded more than once each year, the
terms nominal and effective must be considered.

Nominal Interest Rate, r

Interest rate that does not include any consideration of compounding.

r =interest rate per period x number of periods

A nominal rate r can be stated for any time period.

Nominal rate of r = 2% per month is equal to
2% ∗ 12 months = 24% per year
2% ∗ 3 months = 6% per quarter
2% ∗ 0.231 month = 0.462% per week

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 1 / 29

 Nominal and Effective Interests Statements

Effective interest rate is the actual rate that applies for a stated
period of time. (The actual amount of interest that will accumulate
in a stated period of time.)
The compounding of interest during the time period of the
corresponding nominal rate is accounted for by the effective
interest rate.
Effective interest rate is commonly expressed on an annual basis
as the effective rate, ia , but any time basis can be used.
Effective rate has the compounding frequency attached to the
nominal rate statement (4% per year, compounded monthly)
If compounding frequency is not stated, it is assumed to be the
same as the time period of r , i.e. compounding 1 time during the
time period
All the interest formulas, factors, tabulated values must have the
effective interest rate to properly account for the time value of
money.
Therefore, we should know how to calculate the effective interest
rate value for any nominal or effective rate statement.
Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 2 / 29
 Nominal and Effective Interests Statements

Annual Percentage Rate (APR) and Annual Percentage Yield

(APY) can be used as instead of nominal and effective interest
rates in practice.

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 3 / 29

 Nominal and Effective Interests Statements

There are always three time-based units associated with an interest

rate statement.
Time Period- The period over which the interest is expressed. It is
the t in the statement of r % per time period t (1% per month)
Compounding Period- the shortest time period over which interest
is charged or earned. (8% per year compounded monthly,
therefore CP is month)
Compounding frequency- the number of times that m
compounding occurs within the time period t. If the compounding
period (CP) and the time period t are the same, the compounding
frequency is 1 (1% per month compounded monthly.)
Example
Consider the rate 8% per year compounded monthly.
Time period = 1 year
Compounding period = 1 Month
Compounding frequency = 12 times per year
Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 4 / 29
 Nominal and Effective Interests Statements

So far all the interest rates used have t and m as 1 year (8% per year).
The effective and nominal rates were the same. It is common practice
to express the rates on the same time basis as the compounding
period.

r % per time period t r

icp (Nominal Rate per CP) = =
m compounding per t m

Example
Assume r = 9% per year, compounded monthly, then m = 12 and the
effective rate per the compounding period is found as 9%
12 = 0.75% per
month, compounded monthly.
NOTE: Changing the basic time period t does not alter the
compounding period, month in the previous example. Whenever time
period = compounding period, stated nominal rate is an effective rate.
Therefore, icp is the effective rate per CP too.
Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 5 / 29
 Nominal and Effective Interests Statements

Basically, there are three ways to express interest rates.

Format of Rate Example Effective Rate?

Nominal rate, CP 8 % per year, Find it
compounded quarterly

Nominal rate, t=CP 8 % per year, rate effective for year

compounded yearly
or
2 % per quarter rate effective for quarter
compounded quarterly

Nominal rate, no CP 8 % per year rate effective for year

or
2 % per quarter rate effective for quarter

Effective rate Effective 8.243 % per year, Use given

compounded quarterly

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 6 / 29

 Nominal and Effective Interests Effective Annual Interest Rates

For the Effective Annual Interest rate, time period t is year, and the
compounding period can be any time unit less than a year.
Effective interest rate at any point during the year includes the
interest rate of all previous compounding periods during the year.
Derivation of the effective annual interest rate formula directly
parallels the logic of the future worth relation F = P(1 + i)n .
Rewrite the formula as F = P(1 + ia ), since interest can be
compounded many times a year.
The rate icp per CP must be compounded through all m years to
find the total effect of compounding by the end of year.

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 7 / 29

 Nominal and Effective Interests Effective Annual Interest Rates

r : nominal interest rate per year

m: compounding occurs within the time period t (1 year).
icp : effective interest rate per compounding period (r /m)
ia : effective interest rate per year
P (1+icp)m=P(1+ia)
P (1+icp)m-1
P (1+icp )m-2
P (1+icp)2
P (1+icp)
P

............
0 1 2 m-2 m-1 m

Time

(1 + ia ) = (1 + icp )m
ia = (1 + icp )m − 1
ia = (1 + r /m)m − 1

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 8 / 29

 Nominal and Effective Interests Effective Annual Interest Rates

Example
Kelso obtained a new credit card from a national bank, MBNA, with a
stated rate of 18% per year, compounded monthly. For a $1,000
balance at the beginning of the year, find the effective annual rate and
the total amount owed to MBNA after 1 year, provided no payments
are made during the year.
r (nominal annual rate)=18%, m=12,
icp (interest per CP)= mr = 18%
12 = 1.5% per month
P (1.015) 12=P(1+i a)
P (1.015) 11
P (1.015) 10
P (1.015) 2
P=1000 P (1.015)

............
0 1 2 10 11 12 Month

ia = (1 + icp )12 − 1 = (1.015)12 − 1 = 0.19562

F = 1000(1 + ia ) = 1000(1.19562) = $1, 195.62
Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 9 / 29
 Nominal and Effective Interests Effective Annual Interest Rates

In Class Work 4
Calculate the effective annual interest rates when r =18% per year,
compounded m-ly
Effective Annual Rate
Compounding Period Rate over CP, icp m ia

Year _ _%
1

Semi Annual _ _% _ _%
1 2

Quarter _ _% _ _% _ _% _ _%
1 2 3 4

Month 1 2 3 4 5 6 7 8 9 10 11 12

_ _% in each

1234 24 25 26 28 49 50 51 52

Weekly

_ _ % in each

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 10 / 29

 Nominal and Effective Interests Effective Annual Interest Rates

In Class Work 4
Calculate the effective annual interest rates when r =18% per year,
compounded m-ly
Effective Annual Rate
Compounding Period Rate over CP, icp m ia

Year 18%
1 (1.18)1-1= 18 %
1

Semi Annual 9% 9%
2 (1.09)2-1= 18.81 %
1 2

Quarter 4.5% 4.5% 4.5% 4.5%

4 (1.045)4-1= 19.252 %
1 2 3 4

Month 1 2 3 4 5 6 7 8 9 10 11 12
12
(1.015)12-1= 19.562 %
1.5% in each

1234 24 25 26 28 49 50 51 52

Weekly
52 (1.0034615)52-1= 19.684%

0.34615 % in each

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 11 / 29

 Nominal and Effective Interests Interpolation in Interest Rates

When the effective interest rates are calculated using the formula for ia ,
the resulting rates are usually not integer. Therefore, the engineering
economy factors cannot be obtained directly from the interest factor
tables. There are two alternatives to find the factor value.
1 Use factor formula with ia rate substituted for i
2 Linearly interpolate between tabulated rates.
i or n Factor

Known Value 1
a c
Desired Unlisted ? d
b
Known Value 2
Where a, b, c, and d are differences between the indicated numbers in
the tables. First, set up ratio equation;
c a a
= ⇒c= d
d b b

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 12 / 29

 Nominal and Effective Interests Interpolation in Interest Rates

Example
Determine the value of the A/P factor for an interest rate of 7.3% and n
of 10 years, that is, (A/P, 7.3%, 10).

i Factor

7% 0.14238
a c
7.3% X=? d
b
8% 0.14903

a = 7.3 − 7 = 0.3, b = 8 − 7 = 1, d = 0.14903 − 0.14238 = 0.00665

a 0.3
c = d= 0.00665 = 0.001995
b 1
X = 0.14238 + 0.001995 = 0.144375

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 13 / 29

 Nominal and Effective Interests Effective Interest Rate for any time period

Now, we need to introduce the payment period, the frequency of

payments or receipts. Most of the time the compounding period and
payment period are not the same.
A company deposits money into an account each month that pays
a nominal interest rate of 12% per year, compounded
semiannually.
Compounding period = 6 months
Payment period = 1 month
To evaluate cash flows occurring more frequently than annually,
effective interest rate over the payment period must be calculated.
Let r : nominal interest rate per payment period
Let m: number of compounding periods per payment period
r m
Effective i = (1 + m) −1

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 14 / 29

 Nominal and Effective Interests Effective Interest Rate for any time period

Example
Three suppliers place their bids for the procurement of a major part for
a motor company. The motor company will make semiannual
payments. The bids by the suppliers are given as:
1 9% per year, compounded quarterly,
2 9% per year, compounded monthly,
3 3% per quarter, compounded quarterly.
Determine the effective rate for each bid on the basis of semiannual
payments.
For bid:
0.045 2 2
1 i = (1 + 2 ) − 1 = (1.0225) − 1 = 4.55%
0.045 6 6
2 i = (1 + 6 ) − 1 = (1.0075) − 1 = 4.58%
6 2 2
3 i = (1 + 2 ) − 1 = (1.03) − 1 = 6.09%

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 15 / 29

 Nominal and Effective Interests Effective Interest Rate for any time period

Example
CP
month

1 2 3 4

PP PP
6 Months 6 Months

CP CP CP CP
quarter quarter quarter quarter

1 2 3 4

PP PP
6 Months 6 Months

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 16 / 29

 Nominal and Effective Interests Continuous Compounding

Allowing more and more frequent compounding, increases the number

of compounding periods per time period, m. As m approaches infinity,
the effective interest rate must be written in a new form. First recall the
definition of natural logarithm;
 1 h
limh→∞ 1 + = e = 2.71828
h
The limit of i = (1 + mr )m − 1 as m approaches infinity is found by
setting r /m = 1/h, which makes m = hr .
 r m
limm→∞ i = limm→∞ 1 + −1
m
h 1 h ir
= limh→∞ 1 + −1
h
i = er − 1

This formula compute the effective continuous interest rate when the
time periods on i and r are the same.
Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 17 / 29
 Nominal and Effective Interests Continuous Compounding

Example
For an interest rate of 18% per year, compounded continuously,
calculate the effective monthly and annual interest rates.
Nominal monthly interest rate r = 18%/12 = 1.5%.
Effective monthly rate i% per month =e0.015 − 1 = 1.511%
Nominal annual interest rate r = 18%.
Effective annual rate i% =e0.18 − 1 = 19.72%
An investor requires an effective return of at least 15%. What is the
minimum annual nominal rate that is acceptable for continuous
compounding.

0.15 = er − 1
1.15 = er
ln(1.15) = ln er
r = 0.1397 → 13.97%

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 18 / 29

 Nominal and Effective Interests Equivalence Relations: PP vs. CP

In most of the equivalence computations, the frequency of cash flows

does not equal the frequency of interest compounding. To correctly
perform any equivalence computation, it is essential that the
compounding period and payment period be placed on the same time
basis, and the interest rate be adjusted accordingly.
CP
month

1 2 3 4

PP PP
6 Months 6 Months

CP CP CP CP
quarter quarter quarter quarter

1 2 3 4

PP PP
6 Months 6 Months

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 19 / 29

 Nominal and Effective Interests Single Amounts: PP ≥ CP

When only single-amount cash flows are involved, there are two
correct ways to determine i, n, P/F and F /P factors.
1 Determine the effective interest rate over the compounding period
CP, and set n equal to the number of compounding periods
between P and F .
2 Determine the effective interest rate over the time period t of the
nominal rate, and set n equal to the number of time periods
between P and F .
Example
Find the future amount equivalence of three cash flows at the end of
year 10 at an interest rate of 12% per year, compounded semiannually.
F=?

0 1 2 3 4 5 6 7 8 9 10

1000
1500
3000
Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 20 / 29
 Nominal and Effective Interests Single Amounts: PP ≥ CP

Example
1 Effective rate on CP = 6% per 6 month,compounded semiannually.

F = 1000(F /P, 6%, 20) + 3000(F /P, 6%, 12) + 1500(F /P, 6%, 8)
= 1000(3.2071) + 3000(2.0122) + 1500(1.5938)
= $11, 634

2 Effective annual rate = (1 + 0.12/2)2 − 1 = 0.1236 = 12.36%.

F = 1000(F /P, 12.36%, 10) + 3000(F /P, 12.36%, 6)

+ 1500(F /P, 12.36%, 4)
= 1000(1.1236)10 + 3000(1.1236)6 + 1500(1.1236)4
= $11, 634

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 21 / 29

 Nominal and Effective Interests Series: PP ≥ CP

When uniform or gradient series are included in the cash flow

sequence, we need to determine the effective interest rate over the
frequency of the cash flows.
1 Find the effective i per payment period
2 Determine n as the total number of payment periods.

Example
For the past 7 years, a quality manager has paid $500 every 6 months
for the software maintenance contract of a LAN. What is the equivalent
amount after the last payment, if these funds are taken from a pool that
has been returning 20% per year, compounded quarterly.
F=?

0 1 2 3 4 5 6 7

A=$500

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 22 / 29

 Nominal and Effective Interests Series: PP ≥ CP

Example
F=?

0 1 2 3 4 5 6 7

A=$500

 2
0.1
Effective i per 6-months = 1 + 2 − 1 = 0.1025 = 10.25%.
n=7(2)=14 payment periods.

h (1.1025)14 − 1 i
F = A(F /A, 10.25%, 14) = A
0.1025
= 500(28.4891)
= $14, 244.50

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 23 / 29

 Nominal and Effective Interests Series: PP < CP

Timing of the cash flow transactions between compounding points

introduces the question of how inter-period compounding is
handled.
We will use the no inter-period interest policy
Deposits are assumed to be at the end of the CP (- cash flows)
Withdrawals are assumed to be at the beginning of the CP
Cash flows are forced into PP=CP situation
Example
The cash flow diagram of a project from the project perspective is
given. The applicable interest rate is 12% per year, compounded
quarterly. Find the value of future worth, F at the end of year 1.
Receipts from Company
120
90 45

0 1 2 3 4 5 6 7 10 11 12

8 9 Months

75
150 100 50
200 Payments to Contractor

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 24 / 29

 Nominal and Effective Interests Series: PP < CP

Example
165

90

1 2 3 4 5 6 7 10 11 12
Months
8 9

50
150
200 175

Effective interest rate per quarter, i = 3%.

F = −150(F /P, 3%, 4) − 200(F /P, 3%, 3) − 85(F /P, 3%, 2)

+ 165(F /P, 3%, 1) − 50
= −150(1.03)4 − 200(1.03)3 − 85(1.03)2 + 165(1.03) − 50
= $ − 357.598

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 25 / 29

 Nominal and Effective Interests Series: PP < CP

In Class Work 5
An engineering firm bought a new machine for 3 million dollars. They
estimate a cost of $200,000 per year for all materials, operating and
maintenance costs. The expected life of the machine is 10 years. We
want to find the constant revenue requirement for each 6-month period
that is necessary to recover the initial investment, interest and annual
costs. Find this semiannual A value if capital funds are evaluated at
8% per year using two different compounding periods:
1 8% per year compounded semiannually
2 8% per year compounded monthly
n −1
h i
P/A = (1+i)
i(1+i)n

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 26 / 29

 Nominal and Effective Interests Series: PP < CP

In Class Work 5
A=?

0 1 2 19 20 6 Months
1 2 9 10
Years

200,000
3,000,000

1 Effective rate over 6-months is 8/2 = 4% and Effective annual rate

is (1.042 ) − 1 = 8.16%
20
hX i
P = 3, 000, 000 + 200, 000 (P/F , 4%, k)
k =2,4
= 3, 000, 000 + 200, 000(6.6620) = $4, 332, 400 OR

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 27 / 29

 Nominal and Effective Interests Series: PP < CP

In Class Work 5
A=?

0 1 2 19 20 6 Months
1 2 9 10
Years

200,000
3,000,000

1 Effective rate over 6-months is 8/2 = 4% and Effective annual rate

is (1.042 ) − 1 = 8.16%

P = 3, 000, 000 + 200, 000(P/A, 8.16%, 10)

= 3, 000, 000 + 200, 000(6.6619) = $4, 332, 380
A = 4, 332, 400(A/P, 4%, 20)
= 4, 332, 400(0.07358) = $318, 778

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 28 / 29

 Nominal and Effective Interests Series: PP < CP

In Class Work 5
1 Effective rate over 6-months is 8/2 = 4% and Effective annual rate
is (1.042 ) − 1 = 8.16%
2 Effective rate over one month is 8/12 = 0.666%, Effective
semiannual rate is (1.00666) − 1 = 4.067% and Effective annual
rate is (1.006612) − 1 = 8.299%

P = 3, 000, 000 + 200, 000(P/A, 8.299%, 10)

= 3, 000, 000 + 200, 000(6.6205) = $4, 324, 104
A = 4, 324, 104(A/P, 4.067%, 20)
= 4, 324, 104((0.0740189) = $320, 065.6

Dr.Serhan Duran (METU) IE 347 Week 3 Industrial Engineering Dept. 29 / 29