ENGINEERING ECONOMICS
LECTURE - 09 ASST PROF. ENGR
ALI SALMAN
alisalman@
DEPARTMENT [Link]
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ALI SALMAN 1
Effective Annual Interest Rate
• Example:
– “12% annual rate, compounded monthly”
• Pick this statement apart:
– 12% is the nominal interest rate
– “Compounded monthly” tells us the number of
compounding periods in a year (12)
• The effective interest rate per month is 1%:
– We would like to be able to convert this to an
effective annual interest rate
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Effective Annual Interest Rate
The effective annual interest rate i for a nominal
interest rate r compounded m times per year is:
i = (1 + r / m)m - 1
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Monthly Compounding Example
• Given:
r = 9% per year, compounded monthly
Compounding is monthly, so there are m = 12
compounding periods in a year
Effective monthly rate:
0.09/12 = 0.0075 = 0.75%/month
Effective annual rate:
(1 + 0.0075)12 – 1 = 0.0938 = 9.38%/year
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Example (continued)
• r = 9% is the nominal rate
• “Compounded monthly” means m = 12
• The effective monthly rate is 0.75%/month
• The effective annual rate is 9.38% per year
0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75%
1 2 3 4 5 6 7 8 9 10 11 12
One year duration (12 months)
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Quarterly Compounding Example
• Given r = 9% per year, compounded quarterly
Quarter 1 Quarter 2 Quarter 3 Quarter 4
What is the effective rate?
0.09/4 = 0.0225 = 2.25%/quarter is the
effective quarterly rate
(1 + .0225)4 – 1 = 0.0930 = 9.30%/year is
the effective annual rate 6
Weekly Compounding Example
• Given r = 9% per year, compounded weekly:
– Assume 52 weeks per year
– The effective weekly rate is (0.09/52) = 0.00173
= 0.173%/week
– The effective annual rate is (1 + 0.00173)52 – 1
= 0.0940 = 9.40%/year
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Comparison
• The effective annual interest rate is always greater
than the nominal interest rate:
– You are earning (paying) interest on your interest
• The difference is greater with more frequent
compounding:
– If compounded quarterly, we get 9.30%/year
– If compounded monthly, we get 9.38%/year
– If compounded weekly, we get 9.40%/year
• What if we compound infinitely often?
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Effective Interest Rate per
Payment Period (i)
i [1 r / CK ] 1 C
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 9
Case 0: 8% compounded quarterly
Payment Period = Quarter
Interest Period = Quarterly
1st Q
2nd Q 3rd Q 4th Q
1 interest period
Given r = 8%,
K = 4 payments per year
C = 1 interest period per quarter
M = 4 interest periods per year
i [1 r / CK ]C 1
[1 0.08 / (1)( 4)]1 1
2.000% per quarter
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Case 1: 8% compounded monthly
Payment Period = Quarter
Interest Period = Monthly
1st Q
2nd Q 3rd Q 4th Q
3 interest periods
Given r = 8%,
K = 4 payments per year
C = 3 interest periods per quarter
M = 12 interest periods per year
i [1 r / CK ]C 1
[1 0.08 / (3)( 4)]3 1
2.013% per quarter
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Case 2: 8% compounded weekly
Payment Period = Quarter
Interest Period = Weekly
1st Q
2nd Q 3rd Q 4th Q
13 interest periods
Given r = 8%,
K = 4 payments per year
C = 13 interest periods per quarter
M = 52 interest periods per year
i [1 r / CK ]C 1
[1 0.08 / (13)( 4 )]13 1
2.0186% per quarter
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Effective Interest Rate per Payment Period
with Continuous Compounding
i [1 r / CK ] 1C
where CK = number of compounding periods
per year
continuous compounding => C
i lim[(1 r / CK ) 1]
C
(e )
r 1/ K
1
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Case 3: 8% compounded continuously
Payment Period = Quarter
Interest Period = Continuously
1st Q
2nd Q 3rd Q 4th Q
interest periods
Given r = 8%,
K = 4 payments per year
i er / K 1
e 0.02 1
2.0201% per quarter
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Summary: Effective interest rate per quarter
Case 0 Case 1 Case 2 Case 3
8% 8% 8% 8%
compounded compounded compounded compounded
quarterly monthly weekly continuously
Payments Payments Payments Payments
occur occur occur occur
quarterly quarterly quarterly quarterly
2.000% per 2.013% per 2.0186% per 2.0201% per
quarter quarter quarter quarter
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Which One to Use: r or i
• Some problems state only the nominal interest rate:
– The nominal interest rate is frequently stated for
loans
• The effective interest rate is always the one used in:
– Published interest tables
– time-value-of-money formulas
– Spreadsheet functions
• Remember:
– Always use the effective interest rate in solving
problems
– (Either annual or per period)
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