Lecture slides to accompany

Basics of Engineering Economy

by
Leland Blank and Anthony Tarquin

Chapter 3
Nominal and Effective
Interest Rates

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Chapter 3 – Nominal & Effective Interest

TOPICS
PURPOSE
 Recognize nominal and
effective rates
Perform calculations  Effective interest rates
for interest rates and  Payment period (PP)
cash flows that occur and compounding
on a time basis period (CP)
other than yearly  Single amounts with
PP ≥ CP
 Series with PP ≥ CP
 Single and series with
PP < CP
 Spreadsheet use
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 Sec 3.1 – Nominal and Effective Rate
Statements
Nominal rates Effective rates
Interest rate per time period Interest rate is compounded more
without regard to frequently than once per year
compounding frequency Some statements indicating an
Some nominal statements: effective rate:
 8% per year compounded  15% per year
monthly  effective 8.3% per year
 2% per month compounded compounded monthly
weekly  2% per month compounded
 8% per year compounded monthly
quarterly  effective 1% per week compounded
 5% per quarter compounded continuously
monthly

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Sec 3.2 – Effective Interest Rate Formula

• i = effective rate per some stated period, e.g.,

quarterly, annually
• r = nominal rate for same time period
• m = frequency of compounding per same time period

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 Sec 3.2 – Effective Interest Rate
Time
Compounding Period for period m must
frequency effective i for r equal
Annual annual year 1
Semi-annual annual year 2
Quarterly annual year 4
Monthly annual year 12
Daily annual year 365
Monthly semi-annual 6 months 6
Weekly quarterly quarter 12
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Sec 3.2 – Effective Interest Rate

Example: Find i per year, if m = 4 for
quarterly compounding, and
r = 12% per year

r m
Effective i = (1+ ) 1
m
Stated period for i is YEAR

i = (1 + 0.12/4)4 - 1 = 12.55%

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 Sec 3.2 – Nominal and Effective Rates
Nominal Effective
r m
r = rate/period × periods Effective i = (1+ ) 1
m
Example: Rate is 1.5% per month. Example: Credit card rate is 1.5% per month
Determine nominal rate per compounded monthly. Determine effective rate
quarter, year, and over 2 years per quarter and per year
Qtr: r = 1.5 × 3 mth = 4.5%
Period is quarter:
Year: r = 1.5 ×12 mth = 18% r = 1.5 × 3 mth = 4.5%
= 4.5 × 4 qtr = 18% m=3
i = (1 + 0.045/3)3 – 1 = 4.57% per quarter
2 yrs: r =1.5 × 24 mth = 36%
= 18 × 2 yrs = 36% Period is year: r = 18% m = 12

i = (1 + 0.18/12)12 - 1) = 19.6% per year

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Sec 3.2 – Effective Interest Rate

As m → ∞, continuous compounding is
approached

effective i = (℮r – 1)

Example: r = 14% per year compounded

continuously

i = (℮ 0.14 - 1) = 15.03% per year

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 Sec 3.2 – Nominal and Effective Rates
Using Excel functions to find rates

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Sec 3.3 – Payment Periods (PP)

and Compounding Periods (CP)
PP – how often cash flows occur
CP – how often interest in compounded
If PP = CP, no problem concerning effective i rate

Examples where effective i is involved:

Monthly deposit, quarterly compounding (PP < CP)
Semi-annual payment, monthly compounding (PP > CP)

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 Sec 3.3 – Payment Periods (PP)
and Compounding Periods (CP)
Initial things to observe about cash flows
1. Compare length of PP with CP
PP = CP PP > CP PP < CP
1. Determine types of cash flows present
• Only single amounts (P and F)
• Series (A, G, g)
2. Determine correct effective i and n (same time unit
on both)

Remember: An effective i rate must be

used in all factors
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Sec 3.4 – Equivalence with Single Amounts

If only P and F cash flows are present, equivalence relations are

P = F(P/F, effective i per period, # of periods) [1]
F = P(F/P, effective i per period, # of periods) [2]
Example: Find equivalent F in 10 years if P is $1000 now. Assume
r = 12% per year compounded semi-annually.

- PP = year and CP = 6 months; period is 6 months

- Only single amount cash flows
- Use relation [2] above to find F

F = 1000(F/P, 6% semi-annually, 20 periods)

= 1000(3.2071) = $3207
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 Sec 3.5 – Equivalence with Series and PP ≥ CP
Count number of payments. This is n
Determine effective i over same time period as n
Use these i and n values in factors
Example: $75 per month for 3 years at 12% per year
compounded monthly
PP = CP = month
n = 36 months
effective i = 1% per month

Relation: F = A(F/A,1%,36)

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Sec 3.5 – Equivalence with Series and PP ≥ CP

Count number of payments. This is n
Determine effective i over same time period as n
Use these i and n values in factors

Example: $5000 per quarter for 6 years at 12% per year

compounded monthly
PP = quarter and CP = month → PP > CP
n = 24 quarters
i = 1% per month or 3% per quarter
m = 3 CP per quarter
effective i per quarter = (1 + 0.03/3)3 – 1 = 3.03%

Relation: F = A(F/A,3.03%,24)
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 Sec 3.5 – Equivalence with Series and PP ≥ CP

P = $3M

• First step: Find P for n = 10 annual payments

• Period is year
• CP = 6 months; PP = year; PP > CP
• Effective i per year = (1 + 0.08/2)2 – 1 = 8.16%
Relation: P = 3M + 200,000(P/A,8.16%,10) = $4,332,400
(continued →)
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Sec 3.5 – Equivalence with Series and PP ≥ CP

P = $3M

• Second step: Find A for n = 20 semi-annual amounts

• Period is six months
• CP = 6 months; PP = 6 months; PP = CP
• Effective i per 6 months = 8%/2 = 4%
Relation: A = 4,332,400(A/P,4%,20) = $318,778

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 Sec 3.6 – Equivalence with Series and PP < CP

Example: deposits monthly (PP) with interest

compounded semi-annually (CP)

Result: PP < CP

Usually, interest is not paid on interperiod deposits

For equivalence computations: Cash flows are ‘moved’

to match CP time period

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Sec 3.6 – Equivalence with Series and PP < CP

APPROACH NORMALLY TAKEN

Move cash flows not at end of a compounding period:

 Deposits ( minus cash flows) - to end of period
 Withdrawals (plus cash flows) - to beginning of same
period (which is the end of last period)

Example (next slide): move monthly deposits to match

quarterly compounding. Now, PP = CP = quarter
 Find P, F or A using effective i per quarter
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 Sec 3.6 – Equivalence with Series and PP < CP
Moving cash flows turns top cash flow diagram into bottom

Qtr 1 Qtr 2 Qtr 3 Qtr4

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Sec 3.7 – Spreadsheet Usage

Spreadsheet function format and structure:
Fine effective rate: = EFFECT(nom r%, m)
Nominal r is over same time period as effective i
 Find nominal rate: = NOMINAL(eff i%, m)
Result of nominal is always per year

Example: Deposits are planned as follows: $1000 now,

$3000 after 4 years, $1500 after 6 years. Find F after 10
years. Interest is 12% per year compounded semiannually

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 Sec 3.7 – Spreadsheet Usage

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