BMFG 4623

Engineering Economy
and Management
Nominal and Effective Interest Rates
References:
1. Blank, L and Tarquin, A. Engineering Economy,8thEdition,McGraw Hill, 2017.
2. Sullivan, W.G., Wicks,E.M., and Koelling,C.P., Engineering Economy,17th Edition, Pearson, 2018
3. Park C.S., Contemporary Engineering Economics, Pearson, 5th Edition, 2011

Nor Akramin Mohamad

Faculty of Manufacturing Engineering
Universiti Teknikal Malaysia Melaka
 LEARNING OUTCOMES
1. Explain interest rate statements
2. Apply formula for annual effective interest rates
3. Apply interest rate for any time period
4. Determine payment period (PP) and compounding
period (CP) for equivalence calculations
5. Analyse problem for single cash flows with given CP
6. Analyse problem for series and gradient cash flows with
PP ≥ CP
 Interest Rate Statements
The terms ‘nominal’ and ‘effective’ enter into consideration
when the interest period is less than one year.

New time-based definitions to understand and remember

Interest period (t) – period of time over which interest is expressed. For example,
1% per month.
Compounding period (CP) – Shortest time unit over which interest is charged or earned.
For example,10% per year compounded monthly.

Compounding frequency (m) – Number of times compounding occurs within the interest
period t. For example, at i = 10% per year, compounded
monthly, interest would be compounded 12 times during the
one year interest period.
 Understanding Interest Rate Terminology
A nominal interest rate (r) is obtained by multiplying an interest rate that is
expressed over a short time period by the number of compounding periods in a
longer time period: That is:
r = interest rate per period x number of compounding periods
Example: If i = 1% per month, nominal rate per year is
r = (1)(12) = 12% per year

A nominal rate may be calculated for any time period longer than the time period stated by
using above equation. For example, the interest rate of 1.5% per month is the same as
each of the following nominal rates.

Note that none of these rates mention anything about compounding of interest; they
are all of the form “ r % per time period.”
 Understanding Interest Rate Terminology
An effective interest rate i is a rate wherein the compounding of interest is taken
into account. Effective rates are commonly expressed on an annual basis as an
effective annual rate; however, any time basis may be used.
(effective rates can be obtained from nominal rates via a formula to be discussed later).

The most common form of interest rate statement when compounding occurs over time
periods shorter than 1 year is “% per time period, compounded CP-ly,” for example,
10% per year, compounded monthly, or 12% per year, compounded weekly. An effective
rate may not always include the compounding period in the statement.
If the CP is not mentioned, it is understood to be the same as the time period mentioned with
the interest rate. For example, an interest rate of “1.5% per month” means that interest is
compounded each month; that is, CP is 1 month. An equivalent effective rate statement,
therefore, is 1.5% per month, compounded monthly.

IMPORTANT: Nominal interest rates are essentially simple interest rates. Therefore,
they can never be used in interest formulas.
Effective rates must always be used hereafter in all interest formulas.
 More About Interest Rate Terminology
There are 3 general ways to express interest rates
There are 3 general ways to express interest rates as shown below
as shown below
Sample Interest Rate Statements Comment
i = 2% per month When no compounding period
(1)
i = 12% per year is given, rate is effective

i = 10% per year, comp’d semiannually When compounding period is given

(2)
i = 3% per quarter, comp’d monthly and it is not the same as interest
period, it is nominal

i = effective 9.4%/year, comp’d semiannually When compounding period is given

(3) and rate is specified as effective,
i = effective 4% per quarter, comp’d monthly
rate is effective over stated period
More About Interest Rate Terminology
Three different bank loan rates for electric generation equipment are listed below.
Determine the effective rate on the basis of the compounding period for each rate.
(a) 9% per year, compounded quarterly.
(b) 9% per year, compounded monthly.
(c) 4.5% per 6 months, compounded weekly.

Figure: Relations between interest period t, compounding period CP, and effective interest rate per CP
 Effective Annual Interest Rates
Nominal rates are converted into effective annual rates via the equation:

ia = (1 + i)m – 1
where ia = effective annual interest rate
i = effective rate for one compounding period
m = number times interest is compounded per year

Example: For a nominal interest rate of 12% per year, determine the nominal
and effective rates per year for (a) quarterly, and (b) monthly compounding

Solution: (a) Nominal r / year = 12% per year

Nominal r / quarter = 12/4 = 3.0% per quarter
Effective i / year = (1 + 0.03)4 – 1 = 12.55% per year
(b) Nominal r /month = 12/12 = 1.0% per year
Effective i / year = (1 + 0.01)12 – 1 = 12.68% per year

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Figure: Effective Annual Interest Rates Using Equation, ia

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 Effective Interest Rates
Nominal rates can be converted into effective rates
for any time period via the following equation:

i = (1 + r / m)m – 1
where i = effective interest rate for any time period
r = nominal rate for same time period as i
m = no. times interest is comp’d in period specified for i
Spreadsheet function is = EFFECT(r%,m) where r = nominal rate per period specified for i

Example: For an interest rate of 1.2% per month, determine the nominal
and effective rates (a) per quarter, and (b) per year
Solution: (a) Nominal r / quarter = (1.2)(3) = 3.6% per quarter
Effective i / quarter = (1 + 0.036/3)3 – 1 = 3.64% per quarter

(b) Nominal r /year = (1.2)(12) = 14.4% per year

Effective i / year = (1 + 0.144 / 12)12 – 1 = 15.39% per year
 Effective Interest Rates
Example: For an interest rate of 1.2% per month, determine the nominal
and effective rates (a) per quarter, and (b) per year

Solution:
Diagram for
effectives rate per
quarter

(a) Nominal r / quarter = (1.2)(3) = 3.6% per quarter

Effective i / quarter = (1 + 0.036/3)3 – 1 = 3.64% per quarter Lets draw the
diagram for
effectives
(b) Nominal r /year = (1.2)(12) = 14.4% per year interest rate per
Effective i / year = (1 + 0.144 / 12)12 – 1 = 15.39% per year year
 Example:Effective Interest Rates
Determine the effective (a) quarterly (b) semi-annual and (c) annual interest rates as
follows:
16% per year, compounded quarterly

(a) effective interest rate for quarterly

r = 4% = 0.04 & m = 1
Effective i quarterly = (1 + 0.04 / 1)1 – 1 = 4% per quarter

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 Example:Effective Interest Rates
Determine the effective (a) quarterly (b) semi-annual and (c) annual interest rates as
follows:
16% per year, compounded quarterly

(b) effective interest rate for semi-annually

r = 8% = 0.08 & m = 2
Effective i semi annually = (1 + 0.08 / 2)2 – 1 = 0.0816 = 8.16% per semi annual

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 Example:Effective Interest Rates
Determine the effective (a) quarterly (b) semi-annual and (c) annual interest rates as
follows:
16% per year, compounded quarterly

(c) effective interest rate for annually

r = 16% = 0.16 & m = 4
Effective i annually = (1 + 0.16 / 4)4 – 1 = 0.1699 = 16.99% per annual

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 Example: Effective Interest Rates
Tesla Motors manufactures high-performance battery electric vehicles. An engineer is on a
Tesla committee to evaluate bids for new-generation coordinate-measuring machinery to be
directly linked to the automated manufacturing of high-precision vehicle components. Three
bids include the interest rates that vendors will charge on unpaid balances. To get a clear
understanding of finance costs, Tesla management asked the engineer to determine the
effective semiannual and annual interest rates for each bid. The bids are as follows:

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 rate for each bid on the basis of semiannual periods.
(b) What are the effective annual rates? These are to be a part of the fi nal bid selection.
(c) Which bid has the lowest effective annual rate?

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 Example: Effective Interest Rates
If a credit card charges 1.5% interest rate every month,
determine the nominal and effective interest rate per year
Solution:

Effective i / year = (1 + 0.18/12)12 – 1 = 19.56%

Determine the effective interest rate for 8% per year

compounded quarterly.

Solution:

Effective i / quarter = (1 + 0.08/4)4 – 1 = 0.0824 = 8.24%

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 Example: Effective Interest Rates
Prove the effective rate for each bid.

Nominal Rate Effective Rate

Semi annual Quarterly Daily
Bid 1 5% 5.063% 5.10% 5.13%
Bid 2 10% 10.25% 10.83% 10.52%
Bid 3 15% 15.563% 15.87% 16.18%
Bid 4 20% 21.00% 21.55% 22.13%

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 Effective Interest Rates
A company plans to place money in a new venture capital fund that
currently returns 18% per year, compounded daily. Find the effective rate
is this
( a ) yearly and
( b ) semiannually

Answers:
(a) 19.716 %
(b) 9.415 %

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 Equivalence Relations: PP and CP
New definition: Payment Period (PP) – Length of time between cash flows
In the diagram below, the compounding period (CP) is semiannual and the payment period (PP) is monthly

$1000

Similarly, for the diagram below, the CP is quarterly and the payment period (PP) is semiannual
F=?
i = 10% per year, compounded quarterly
0 1 2 3 4 5 Years
0 1 2 3 4 5 6 7 8 Semi-annual periods

A = $8000
Semi-annual PP
 Single Amounts with PP > CP
For problems involving single amounts, the payment period (PP) is usually
longer than the compounding period (CP). For these problems, there are an infinite
number of i and n combinations that can be used, with only two restrictions:
(1) The i must be an effective interest rate, and
(2) The time units on n must be the same as those of i
(i.e., if i is a rate per quarter, then n is the number of quarters between P and F)

There are two equally correct ways to determine i and n

Method 1: Determine effective interest rate over the compounding period CP, and
set n equal to the number of compounding periods between P and F

Method 2: Determine the effective interest rate for any time period t, and
set n equal to the total number of those same time periods.
Example: Single Amounts with PP ≥ CP
How much money will be in an account in 5 years if RM10,000 is
deposited now at an interest rate of 1% per month? Use three different
interest rates: (a) monthly, (b) quarterly , and (c) yearly.

(a) For monthly rate, 1% is effective [n = (5 years)×(12 CP per year = 60]

F = 10,000(F/P,1%,60) = RM18,167
months i and n must always
effective i per month have same time units

(b) For a quarterly rate, effective i/quarter = (1 + 0.03/3)3 –1 = 3.03%

F = 10,000(F/P,3.03%,20) = RM18,167
quarters i and n must always
effective i per quarter have same time units

(c) For an annual rate, effective i/year = (1 + 0.12/12)12 –1 = 12.683%

F = 10,000(F/P,12.683%,5) = RM18,167
years i and n must always
effective i per year have same time units
Example: Single Amounts with PP ≥ CP
Over the past 10 years, Gentrack has placed varying sums of money into a special
capital accumulation fund. The company sells compost produced by garbage-to-
compost plants in the United States and Vietnam. Figure below is the cash flow
diagram in $1000 units.

Find the amount in the account now (after 10 years) at an interest rate of 12% per
year, compounded semiannually.
Example: Single Amounts with PP ≥ CP
Example: Single Amounts with PP ≥ CP
 Series with PP ≥ CP
For series cash flows, first step is to determine relationship between PP and CP

Determine if PP ≥ CP, or if PP < CP

When PP ≥ CP, the only procedure (2 steps) that can be used is as follows:

(1) First, find effective i per PP

Example: if PP is in quarters, must find effective i/quarter
(2) Second, determine n, the number of A values involved
Example: quarterly payments for 6 years yields n = 4×6 = 24

Note: Procedure when PP < CP is not discussed in this syllabus

 Example: Series with PP ≥ CP
How much money will be accumulated in 10 years from a deposit
of $500 every 6 months if the interest rate is 1% per month?

Solution: First, find relationship between PP and CP

PP = 6 months, CP = one month; Therefore, PP > CP

Since PP > CP, find effective i per PP of 6 months

Step 1. i /6 months = (1 + 0.06/6)6 – 1 = 6.xx%

Next, determine n (number of 6-month periods)

Step 2: n = 10(2) = 20 six month periods

Finally, set up equation and solve for F

F = 500(F/A,6.xx%,20) = $18,692 (by factor or spreadsheet)
 Example: Series with PP ≥ CP
For the past 7 years, FKP Energy has paid $500 every 6 months for a software
maintenance contract.
Find the equivalent total amount after the last payment, if these funds are taken
from a pool that has been returning 8% per year, compounded quarterly?
 Exercise
Two bids include the interest rates that vendors will charge on unpaid
balances as follow:
Vendor 1: 8% per year, compounded monthly
Vendor 2: 9% per year, compounded semiannually

Recommend which vendor should be selected.

Solutions:
Compare using annual effective interest rate.
Vendor 1: effective interest rate, 8.34% per year
Vendor 2:effective interest rate, 9.20% per year

Vendor 1 have lower annual effective interest rate, so select Vendor 1

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 Exercise
Hakim has placed varying sums of money into an investment fund as
show in below figure that give return of 16 % per year, compounded
semi-annually.

Calculate the amount in the account after 8 years.

Solutions:
Two approach, can use
a. Annual effective interest rate
b. Semi Annual effective interest rate
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a. Annual
effective
interest
rate

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Solutions:
b. Semi
Annual
effective
interest rate

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 Exercise
Nabhan has placed varying sums of money into an investment
fund. Figure below shows the cash flow diagram.
Analyse the amount in the account after 10 years at interest rate
of 12 % per year, compounded quarterly.

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 Summary of Important Points
1. Must understand: interest period, compounding period,
compounding frequency, and payment period
2. Nominal interest rate , r is the interest rate without considering the
effect of any compounding.
3. Effective interest rate is the interest rate taking into account the
effect of any compounding
4. Always use effective rates in interest formulas

5. Interest rates are stated different ways; must know how to get
effective rates
6. For single amounts, make sure units on i and n are the same
7. For uniform series with PP ≥ CP, find effective i over PP