Ch 3 Understanding money management
1. nominal & effective
interest rates
2. equivalence
calculations using
effective interest rates
3. debt management
If payments occur more
frequently than annual,
how do you calculate
economic equivalence?
If interest period is other
than annual, how do
you calculate economic
equivalence?
How are commercial
loans structured?
How should you
manage your debt?
Nominal vs. effective interest rates
Nominal interest rate:
rate quoted based on
an annual period
(APR)
Effective interest rate:
actual interest earned or
paid in a year (or some
other time period)
Example: 18% compounded monthly
interest rate per month: i = 18%/12 = 1.5%
no. interest periods per year: N = 12
borrow: bank charges 1.5% interest each month on
your unpaid balance
deposit: you earn 1.5% interest each month on your
remaining balance
18% compounded monthly
Question: Suppose that you invest $1,000 for 1 year at
18% compounded monthly. How much interest
would you earn?
F = $1,000(1 + i)N = $1,000(1 + 0.015)12 = $1,195.60
i = 0.1956 19.56%
18%
1
= 1.5%
10
11
12
Effective annual interest rate (yield)
ia = (1 + r/M)M - 1
r = nominal interest rate per year (APR)
ia = effective annual interest rate
M = number of interest periods per year
18%
1
10
11
12
18% compounded monthly 1.5% per month for 12 months
19.56 % compounded annually
Practice problems
If your credit card calculates interest based on 12.5%
APR, what are your monthly interest rate & annual
effective interest rate?
If your credit cards current outstanding balance is
$2,000 & you decide to skip payments for 2 months,
what would be the total balance 2 months from now?
monthly: i =
12.5%
12
= 1.0417%
effective annual: ia = (1 + 1.010417)12 = 13.24%
balance in 2 mo.: F = $2,000(F/P, 1.0417%,2) = $2,041.88
Practice problem
Suppose your savings account pays 9% interest
compounded quarterly. If you deposit $10,000 for one
year, how much would you have at the end of the year?
Practice problem
Suppose your savings account pays 9% interest
compounded quarterly. If you deposit $10,000 for one
year, how much would you have at the end of the year?
(a) Interest rate per quarter:
9%
i=
= 2.25%
4
(b) Annual effective interest rate:
ia = (1 + 0.0225) 4 1 = 9.31%
(c) Balance at the end of one year (after 4 quarters)
F = $10, 000( F / P , 2.25%, 4)
= $10, 000( F / P , 9.31%,1)
= $10, 9 31
Brute force method of solution
First quarter
base amount
+ interest (2.25%)
$10,000
+ $225
Second quarter
= new base amount
+ Interest (2.25%)
= $10,225
+$230.06
Third quarter
= new base amount
+ Interest (2.25%)
= $10,455.06
+$235.24
Fourth quarter
= new base amount
+ interest (2.25 %)
= value after one year
= $10,690.30
+ $240.53
= $10,930.83
Effective annual interest rate (9% compounded quarterly)
Example 3.4: Calculating auto loan payments
Given:
Invoice price = $21,599
Sales tax at 4% = $21,599 (0.04) = $863.96
Dealers freight = $21,599 (0.01) = $215.99
Total purchase price = $22,678.95
Down payment = $2,678.95
Dealers interest rate = 8.5% APR, monthly compounding
Length of financing = 48 months
Find: monthly payment
Solution: Payment period = Interest period
$20,000
1 2
3 4
48
A
Given: P = $20,000, r = 8.5% per year
K = 12 payments per year
N = 48 payment periods
Find A:
M = 12 compounding periods per year:
i = r/M = 8.5%/12 = 0.7083% per month
N = (12)(4) = 48 months, or payment periods
A = $20,000(A/P, 0.7083%,48) = $492.97
Suppose you want to pay off the remaining loan in lump sum right
after making the 25th payment. How much would this lump be?
$20,000
1 2
48
24 25
0
$492.97
25 payments that
were already made
$492.97
23 payments that
are still outstanding
P = $492.97 (P/A, 0.7083%, 23) = $10,428.96
Practice problem
You have a habit of drinking a cup of Starbuck coffee ($2.00
a cup) on the way to work every morning for 30 years. If
you put the money in the bank for the same period, how
much would you have, assuming your accounts earns 5%
interest compounded daily.
NOTE: Assume you drink a cup of coffee every day
including weekends.
Practice problem
You have a habit of drinking a cup of Starbuck coffee ($2.00
a cup) on the way to work every morning for 30 years. If
you put the money in the bank for the same period, how
much would you have, assuming your accounts earns 5%
interest compounded daily.
NOTE: Assume you drink a cup of coffee every day
including weekends.
5%
i=
= 0.0137% per day
365
N = 30 365 = 10,950 days
F = $2( F / A, 0.0137%,10950)
= $50,831
Effective interest rate per payment period
payment period
interest period
payment period
interest period
payment period
interest period
Effective interest rate per payment period
i = [1 + r/CK]C - 1
C = number of interest periods per payment period
K = number of payment periods per year
CK = total number of interest periods per year, or M
r / K = nominal interest rate per payment period
12% compounded monthly, quarterly payments
One year
1st
2nd
3rd
1% 1% 1%
3.03%
12.68%
Effective interest rate per quarter
i = (1 + 0 . 01 ) 3 1 = 3 . 030 %
Effective annual interest rate
i a = ( 1 + 0 .0 1 ) 1 2 1 = 1 2 .6 8 %
i a = ( 1 + 0 .0 3 0 3 0 ) 4 1 = 1 2 .6 8 %
4th
Effective interest rate per payment period w/
continuous compounding
i = [(1 + r/CK)C 1]
CK = number of compounding periods per year
for continuous compounding: C
i = lim[(1 + r/CK)C 1] = (er)1/K - 1
Example: effective interest rate per quarter
i = [(1 +
r/CK)C
1]
r = 0.08
K = 4 payments per year
compound
quarterly
compound monthly
compound weekly
compound
continuously
C=1
M=4
C=3
M = 12
C = 13
M = 52
i = [1 + 0.08/4]1 -1
i = [1 + 0.08/12]3 -1
i = [1 + 0.08/52]13 -1 i = e0.02 -1
2.000% per qtr
2.013% per qtr
2.0186% per qtr
2.0201% per qtr
Example 3.5 Discrete case: quarterly deposits
with monthly compounding
F=?
Suppose you make
equal quarterly deposits
of $1,000 into a fund that
pays interest at 12%
compounded monthly.
Find the balance at the
end of year 3.
Year 1
0
3 4
Year 2
5
Year 3
8
9 10 11 12
A = $1,000
quarters
M = 12 compounding periods/year
K = 4 payment periods/year
C = 3 interest periods per quarter
i = [1 + 0 .12 /( 3)( 4 )] 3 1 = 3 .030 %
N = 4(3) = 12
F = $1,000 (F/A, 3.030%, 12) = $14,216.24
Continuous case: Quarterly deposits with
continuous compounding
Year 1
0
Year 2
4
Year 3
8
F=?
9 10 11 12
quarters
A = $1,000
K = 4 payment periods/year
C = interest periods per quarter
i = e0.12/ 4 1
= 3.045% per quarter
N = 4(3) = 12
F = $1,000 (F/A, 3.045%, 12) = $14,228.37
Practice problem
A series of equal quarterly payments of $5,000 for 10 years
is equivalent to what present amount at an interest rate
of 9% compounded
a. quarterly
b. monthly
c. continuously
A = $5,000
0
1
40 Quarters
Quarterly
A = $5,000
Payment period : Quarterly
Interest Period: Quarterly
0
1
40 Quarters
9%
i=
= 2.25% per quarter
4
N = 40 quarters
P = $5,000( P / A, 2.25%, 40)
= $130,968
Monthly
A = $5,000
Payment period : Quarterly
Interest Period: Monthly
0
1
40 Quarters
9%
i=
= 0.75% per month
12
i p = (1 + 0.0075)3 = 2.267% per quarter
N = 40 quarters
P = $5,000( P / A, 2.267%, 40)
= $130,586
Continuously
A = $5,000
Payment period : Quarterly
Interest period: Continuously
0
1
40 Quarters
i = e0.09/ 4 1 = 2.276% per quarter
N = 40 quarters
P = $5,000( P / A, 2.276%, 40)
= $130,384
Example 3.7 Loan repayment schedule
For a $5,000 loan repaid over 2 years at 12%
develop the monthly loan repayment schedule
showing interest & principal for each period.
$5,000
A = $5,000(A/P, 1%, 24) = $235.37
i = 1% per month
22 23 24
A = $235.37
Consider the 7th payment ($235.37)
a. How much is interest?
b. What is the amount of principal payment?
Solution
How much is interest?
What is the amount of principal payment?
W O utstanding balance at the end of period 6:
(N ote: 18 outstanding paym ents)
B 6 = $235.37 ( P / A ,1% ,18) = $3, 859.66
W Interest paym ent for period 7:
IP7 = $3, 859.66(0.01) = $38.60
W P rincipal paym ent for period 7:
P P7 = $235.37 $38.60 = $196.77
N ote: IP7 + P P7 = $235.37
1
2
3
4
5
6
7
8
Exam ple 3.7
C ontract am ount
C ontract period
APR (% )
M onthly Paym ent
Loan Repaym ent Schedule
$ 5,000.00
24
12
($235.37)
T otal paym ent
T otal interest
$ 5,648.82
$648.82
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
Paym ent N o.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
Paym ent
Size
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
($235.37)
Principal
Paym ent
($185.37)
($187.22)
($189.09)
($190.98)
($192.89)
($194.82)
($196.77)
($198.74)
($200.73)
($202.73)
($204.76)
($206.81)
($208.88)
($210.97)
($213.08)
($215.21)
($217.36)
($219.53)
($221.73)
($223.94)
($226.18)
($228.45)
($230.73)
($233.04)
Interest
paym ent
($50.00)
($48.15)
($46.27)
($44.38)
($42.47)
($40.54)
($38.60)
($36.63)
($34.64)
($32.63)
($30.61)
($28.56)
($26.49)
($24.40)
($22.29)
($20.16)
($18.01)
($15.84)
($13.64)
($11.42)
($9.18)
($6.92)
($4.64)
($2.33)
Loan
Balance
$4,814.63
$4,627.41
$4,438.32
$4,247.33
$4,054.44
$3,859.62
$3,662.85
$3,464.11
$3,263.38
$3,060.65
$2,855.89
$2,649.08
$2,440.20
$2,229.24
$2,016.16
$1,800.96
$1,583.60
$1,364.07
$1,142.34
$918.40
$692.21
$463.77
$233.04
$0.00
Example 3.9 buying versus lease decision
debt financing
Lease financing
Price
$14,695
$14,695
Down payment
$2,000
APR (%)
Monthly payment
Length
3.6%
$372.55
$236.45
36 months
36 months
Fees
$495
Cash due at lease end
$300
Purchase option at lease end
Cash due at signing
$8.673.10
$2,000
$731.45
Accounting data - buying vs. lease
Cash outlay for buying : $25,886
Down payment: $2,100
Car Loan at 8.5%
(48 payments of $466): $22,368
Sales tax (at 6.75%): $1,418
Cash outlay for leasing : $15,771
Lease (48 payments of $299) : $14,352
Sales tax (at 6.75%): $969
Document fee: $450
Refundable security deposit (not
included in total) : $300
Which interest rate to use to compare
these options?
Your earning interest rate = 6%
Debt financing:
Pdebt = $2,000 + $372.55(P/A, 0.5%, 36)
- $8,673.10(P/F, 0.5%, 36) = $6,998.47
Lease financing:
Please = $495 + $236.45 + $236.45(P/A, 0.5%, 35)
+ $300(P/F, 0.5%, 36) = $8,556.90
Summary
Financial institutions often quote interest rate based on
an APR.
In all financial analysis, we need to convert the APR into
an appropriate effective interest rate based on a
payment period.
When payment period and interest period differ,
calculate an effective interest rate that covers the
payment period. Then use the appropriate interest
formulas to determine the equivalent values
