Chapter- 4 b

Engineering Economics

College of Biomedical Engineering and Applied Science

Nominal Interest Rates:

Nominal interest rate ( r ) is an interest rate

that does not include any consideration of
compounding, by definition,

r =Interest rate per period ×Number of Periods

It may be stated for any time period such as 1

year, 6 months, quarter Month, week, day etc.

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Nominal Interest Rates:

r = 1.5% per month × 24 months

= 36% per two year period
r = 1.5% per month × 12 months
= 18% per year period
r = 1.5% per month × 6 months
= 9% per Semiannual period
r = 1.5% per month × 3 month
= 4.5% per quarter

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 Effective Interest Rate:
•Effective interest rate is the actual rate that applies
for 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.
•It is commonly expressed on an annual basis as the
effective annual rate but any time basis Can be used.
•An effective rate has the compounding frequency
attached to the nominal rate Statement.

•If the compounding frequency is not stated, it is

assumed to be the same period of r, in which case,
the nominal and effective rates have the same value.
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Effective Interest Rate:
Examples
12% per year, compounded monthly 
12% per year, compounded quarterly 
Compounding
 more often
 than time
3 % per year, compounded monthly
 period
6 % per 6 months, compounded weekly


3 % per quarter, compounded quarterly

Compounding
same as than
time period
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Effective Interest Rate:

General Format

r % per time period t, compounded m-ly

All the interest formulas, factors, tabulated values, and

spreadsheet relations must have the effective interest
rate to properly account for the time value of money.

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Effective Interest Rate:

Definition of Terms

Time Period:
The basic time unit of the interest rate.

Compounding Period (CP):

The time unit used to determine the effect of the interest.

Compounding Frequency (m):

The number of times that compounding occurs within the
time Period t.
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Effective Interest Rate:

r %per time period t

Effective rate per CP=
m compounding periods per t

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Example 1:

The different bank loan rates for three separate

electric generation equipment projects are listed
below. Determine the effective rate on the basis
of the compounding period for each quote.

- 9% per year, compounded quarterly.

- 9% per year, compounded monthly.
- 4.5% per 6-months, compounded weekly.

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Solution: Example

- 9% per year, compounded quarterly

2.25% 2.25% 2.25% 2.25%

r 9
i   2.25%
m 4

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Solution: Example

- 9% per year, compounded monthly

0.75%

r 9
i    0.75%
m 12

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Solution: Example

- 4.5% per 6-months, compounded weekly

0.173%

1 9 26
r 9
i   0.173%
m 26

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Ways to express Nominal and Effective Interest
Rates:

Format of Rate Statement:

Nominal Rate Stated, Compounding period Stated

Examples of Statement:
8% per year, compounded quarterly

What about the Effective Rate?

Find Effective Rate

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Ways to express Nominal and Effective Interest
Rates:

Format of Rate Statement:

Effective rate stated.

Examples of Statement:
8.243% per year, compounded quarterly.

What about the Effective Rate?

Use effective rate directly.

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Ways to express Nominal and Effective Interest
Rates:

Format of Rate Statement:

Interest rate stated, no compounding period stated

Examples of Statement:
8% per year or 2% per quarter

What about the Effective Rate?

Rate is effective only for time period stated: find
effective rate for all other time periods.
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Effective Annual Interest Rates:

r = nominal interest rate per year.

m = number of compounding periods per year.

i = effective interest rate per CP.

i a = effective interest rate per year.

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Effective Annual Interest Rates:

P 1 + i  P 1 + i 
m-1 m

P 1 + i 
3
P 1 + i 
m-2

P 1 + i 
2

P 1 + i 

i i i i i i
1 m-2 m
2 3
m -1

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Effective Annual Interest Rates:

If I a be the annual effective interest rates then

F = P 1 + i a 

The rate i per CP must be compounded through

all m Periods to obtain the total effect of
compounding by the end of the year.

F = P 1 + i 
m

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Effective Annual Interest Rates:

Comparing the two, we get

m
ia = (1 + i) - 1

Above equation calculates the effective annual

interest rate for any number of compounding
periods when I is the rate for one compounding
period.
!!! It is also possible to determine the nominal annual
interest rate
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Example 2:

Jacki obtained a new credit card from a national

bank, MBNA with a stated rate of 18% per year,
compounded monthly. For a $1000 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.

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Solution: Example
i a = 1 + i  - 1
m

= 1  0.015  1  0.19562
12

F = $1000(1.19562)  $1195.62

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Effective Interest Rates for Any Time Period:

CP CP
6 months 6 months

0 1 2 3 4 5 6 7 8 9 10 11 12
months
1

PP
1 months

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It is important to distinguish between payment
period and compounding period because in many
circumstances they do not coincide.

To evaluate the cash flows that occur more

frequently than Annually, that is, PP < 1 year, the
effective interest rate over the PP must be used
in the engineering economy analysis.

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Effective Interest Rate Can be Generalized:

Effective i  1  r / m   1
m

Where

r = Nominal Interest Rate Per Payment Period (PP)

m = number of compounding periods per payment period

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Example 3:
Visteon, a spin-off company of Ford Motor Company,
supplies major automobile components to auto
manufactures worldwide and is Ford’s largest
supplier. An engineer is on a Visteon committee to
evaluate bids for new generation coordinate
measuring machinery to be directly linked to the
automated manufacturing of high-precision
components. Three vendors bids include the interest
rates. Visteon will make payments on semiannual
basis only. The engineer is confused about the
effective interest rates- what they are annually and
over the payment period of 6 months.
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 Bid # 1: 9% per year, compounded quarterly
Bid # 2: 3% per quarter, compounded quarterly
Bid # 3: 8.8 % per year, compounded monthly

a) Determine the effective interest rate for each bid on the

basis of semiannual payments, and construct cash flow
diagrams for each bid rates
b) What are the effective annual rates? These are to be a
part of the final bid selection.
c) Which bid has the lowest effective annual rate?

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Solutions
(a) Payment Period PP = 6 month
Nominal Interest Rates r = 9% per year
= 4.5% per 6 months

CP, m = 2 quarters per 6-months

Effective i% per 6-months =

2
 0.045 
1    1  1.0455  1  4.55%
 2 
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 Semiannual Rates

Bid Nominal per 6 CP per PP Effective i

Months, r m
1 4.5% 2 4.55%
2 6.0% 2 6.09%
3 4.4% 6 4.48%

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b) For the effective annual rate

Payment Period PP = 1 year

Nominal Interest Rates r = 9% per year

CP, m = 4 quarters per

Effective i% per year =

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 0.09 
1    1  1.0931  1  9.31%
 4 

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 Annual Rates

Bid Nominal per CP per Effective i

year, r year m
1 9.0% 4 9.31%
2 12.0% 4 12.55%
3 8.8% 12 9.16%

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c)

Bid #3 includes the lowest effective annual rate of 9.16%,

which is equivalent to an effective semiannual rate
of 4.48%

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Cash Flow Diagram

CP CP CP CP
1 quarter 1 quarter 1 quarter 1 quarter

1 2 3 4

PP PP
6 months 6 months

Quarterly Compounding

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Cash Flow Diagram

CP = 1 months

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

Monthly compounding

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Example 4:

A dot com company plans to place money in a

new venture capital fund that currently returns
18% year, compounded daily. What effective
interest rate is this (a) yearly and (b)
semiannually?

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Solutions

a) r = 18% m = 365 days

365
 0.18 
Effective i% per year  1    1  19.716%
 365 
b) r = 9% m = 182 days

182
 0.09 
Effective i% per year  1    1  9.415%
 182 

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 Equivalence Relations (Single Payment)
PP  CP
When only single-amount cash flows are involved, there
are two equally correct ways to determine I and n for P/F
and F/P factors.

Method 1:

• Determine the effective interest over the compounding

period CP.
• Set n equal to the number of compounding periods
between P and F.

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The relations to calculate P and F are:

P = F(P/F, effective i% per CP, total number of periods n)

F = P(P/F, effective i% per CP, total number of periods n)

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 Method 2

• Determine the effective interest rate for time period t

of the nominal rate,
• set n equal to the total number of periods using this same
time period.
• The P and F relations are same with the term effective
i% per t substituted for the interest rates.

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Example 5:
An engineer working as a private consultant made
deposits into a special account to cover unreimbursed
travel expenses. Cash flow diagram is shown. Find the
amount in the account after 10 years 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
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Method I

Effective rate i = 6% per 6 month period

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

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 Method 2

Express the effective annual rate, based on semiannual

compounding.

2
 0.12 
Effective i% per year  1    1  12.36%
 2 

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

= 1000(3.2071) + 3000(2.0122) + 1500(1.5938)
= $11,634

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Equivalence Relations (Series)
PP  CP
When cash flows involve a series (i.e. A, G, g) and the
payment period equals or exceeds the compounding period
In length,

• Find the effective i per payment period

• Determine n as the total number of payment periods

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 Example 6:

For the past seven 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?

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Solution

PP > CP

i = 20% per year, compounded quarterly F=?

0 1 2 3 4 5 6 7

A = $500

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Effective i% per 6-months =
2
 0.1 
1    1  10.25%
 2 

F = A(F/A,10.25%,14)
= 500(28.4895)
= $14,244.50

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Example 7:

Suppose you plan to purchase a car and carry a

loan of $12,500 at 9% per year, compounded
monthly. Payments will made monthly for 4 years.
Determine the monthly payment.

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Solution
Effective i% per months =

r 9%
  0.75%
m 12

A = $12,500(A/P,0.75%,48)
= 12,500(0.02489) = $311.13

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Equivalence Relations: Single amounts and Series with

PP < CP

How inter period compounding is handled?

There are two policies:

Deposits is regarded as deposited at the end of

the compounding period.

Withdrawals are all regarded as with drawn at

the beginning.

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Example 8:

Rob is the on-site coordinating engineer for Alcoa Aluminum,

where an under-renovation mine has new ore refining
equipment being installed by a local contractor. Rob developed
A cash flow diagram in figure in $1000 units from the project
perspectives. Included are payments to the contractor he has
authorized for the current year and approved advances from
Alcoa’s home office. He knows that the interest rate on
equipment “field projects” such as this is 12% per year,
compounded quarterly, and that Alcoa does not bother with
Inter period compounding of interest. Will Rob’s project finances
Be in “red” or the “black” at the end of the year? By How much?

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 Cash Flow Diagram
Receipt to office
$120
$90 $45
0 1 Year

0 1 2 3 4 5 6 7 8 9 10 11 12 Month
$75 $50
$100
$150 $200

Payment to contractor

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 Moved Cash Flow Diagram

$165
$90

0 1 2 3 4 Year

0 1 2 3 4 5 6 7 8 9 10 11 12 Month
$50
$175
$150 $200

Effective interest rate = 3%

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F  1000[150( F / P,3%,4)  200( F / P,3%,3)
 (175  90)( F / P,3%,2)  165( F / P,3%,1)  50]

 $  357,592

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