ENGINEERING ECONOMY

CONTINUOUS COMPOUNDING, NOMINAL AND EFFECTIVE RATE OF ITENREST,

and ORDINARY ANNUITY

LEARNING CONTENT

Continuous Compounding
- is based on the assumption that cash payments occur once
per year but compounding is continuous throughout the year.

𝐹 = 𝑃𝑒 (𝑁𝑅)𝑁

Where:

P = principal
𝑒 = 2.71828…
NR = Nominal Rate
N = Number of Years
𝑒 (𝑁𝑅)𝑁
= continuous compounding compound
amount factor.

- The present worth of continuous compounding is:

𝐹
𝑃 = ⅇ𝑁𝑅(𝑁)

Difference between Nominal and Effective Rate of Interest

Rate of Interest
- is the cost of borrowing money. It also refers to the
amount earned by a unit principal per unit time.

2 Types of Rates of Interest

1. Nominal Rate of Interest

- defined as the basic annual rate of interest.

2. Effective Rate of Interest

- defined as the actual or the exact rate of interest
earned on the principal during a one-year period.

MODULE 2: CONTINUOS COMPOUNDING, NOMINAL AND EFFECTIVE RATE OF

INTEREST and ORDINARY ANNUITY
1|PAGE
 Example:

1. A principal is invested at 5% compounded quarterly.

- In this statement, the nominal rate is 5% while the effective is

greater than 5% because of the compounding which occurs
four times a year. The following formula is used to determine
the effective rate of interest:

𝐸𝑅 = [1 + ⅈ ]𝑚 − 1
Where:

m = number of interest period per year(MODE OF

COMPOUNDING)
ⅈ = interest per period
𝑁𝑅
ⅈ= 𝑚

or

𝑁𝑅 𝑚
𝐸𝑅 = [1 + ] −1
𝑚

Note: ⅈ = NR if the mode of compounding is annually

Substituting the values of m and i:

0.05 4
𝐸𝑅 = [1 + ] −1
4

𝐸𝑅 = 0.0509
𝐸𝑅 = 5.09%

So, the actual interest rate is not just 5% but 5.09%. However, the
effective rate and nominal rate are equal if the mode of compounding is per
annum or annually.

Example:

1. An interest rate is quoted as being 7.5% compounded

quarterly. What is the effective annual interest rate?

MODULE 2: CONTINUOS COMPOUNDING, NOMINAL AND EFFECTIVE RATE OF

INTEREST and ORDINARY ANNUITY
2|PAGE
 Solution:

𝑖 𝑚
𝐸𝑅 = [1 + 𝑚] − 1
0.075 4
𝐸𝑅 = [1 + ] −1
4

𝐸𝑅 = 0.0771

𝑬𝑹 = 𝟕. 𝟕𝟏%

2. P1,500.00 was deposited in a bank account, 20 years ago.

Today it is worth P3,000.00. Interest is paid semi-annually. Determine the
interest rate paid on this account.

Solution:

𝐹 = 𝑃 (1 + ⅈ )𝑛

( )
0.035 𝑛 2
3,000 = 1,500 (1 + )
2

2 = (1 + 0.5𝑁𝑅)30

NR = 0.035

NR = 3.5%

3. The effective rate of 14% compounded semi-annually is?

Solution:

𝑖 𝑚
𝐸𝑅 = [1 + ] − 1
𝑚

0.14 2
𝐸𝑅 = [1 + ] −1
2

𝐸𝑅 = 0.1449

𝑬𝑹 = 𝟏𝟒. 𝟒𝟗 %

MODULE 2: CONTINUOS COMPOUNDING, NOMINAL AND EFFECTIVE RATE OF

INTEREST and ORDINARY ANNUITY
3|PAGE
 Annuity
- Is defined as a series of equal payments occurring at equal
payments occurring at equal interval of time.

TYPES OF ANNUITY

1. Ordinary Annuity
2. Annuity Due
3. Deferred Annuity
4. Perpetuity

ORDINARY ANNUITY

- Is a type of annuity where the payments are made at the end

of each period beginning from the first period.

Formula:

Future Worth

𝐴[(1+𝑖)𝑛 −1]
𝐹=
𝑖

Present Worth

MODULE 2: CONTINUOS COMPOUNDING, NOMINAL AND EFFECTIVE RATE OF

INTEREST and ORDINARY ANNUITY
4|PAGE
 𝐴[(1+𝑖)𝑛 −1]
𝑃= 𝑖(1+𝑖)𝑛

Where:

i = interest per period

n =number of periods
A = uniform payment

Example:

1. A man purchased on monthly installment a P 100,000 worth of

land. The interest rate is 12% nominal and payable in 20 years. What is the
monthly amortization?

Solution:

𝐴[(1+𝑖 )𝑛 −1]
𝑃= 𝑖 (1+𝑖 )𝑛

0.12 12(20)
𝐴[(1+ ) −1]
12
100,000 = 0.12 0.12 12(20)
( 12 )(1+ 12 )

𝑨 = 1,101.08

2. What is the accumulated amount of five year annuity paying

P6,000 at the end of each year, with interest at 15% compounded annually?

Solution:

MODULE 2: CONTINUOS COMPOUNDING, NOMINAL AND EFFECTIVE RATE OF

INTEREST and ORDINARY ANNUITY
5|PAGE
 𝐴[(1+𝑖)𝑛 −1]
𝐹= 𝑖

6000[(1+0.15)5 −1]
𝐹= 0.15

𝑭 = 𝟒𝟎, 𝟒𝟓𝟒. 𝟐𝟗

3. A debt of P 10,000 with 10% interest compounded semi-annually

is to be amortized by semi-annual payment over the next 5 years. The first due
in 6 months. Determine the semi-annual payment.

Solution:

𝐴[(1+𝑖 )𝑛 −1]
𝑃= 𝑖 (1+𝑖 )𝑛

0.10 2(5)
𝐴[(1+ ) −1]
2
10,000 = 0.10 0.10 2(5)
(1+ 2 )
2

𝑨 = 𝟏, 𝟐𝟗𝟓. 𝟎𝟓

Activity

Solve the following problems.

1. Find the nominal rate that if converted quarterly could be

used instead for 15% compounded semiannually?
2. What amount would have to be invested at the end of each
year for the next 8 years at 4% compounded semi-annually in order to have
P5,000 at the end of the time?
3. If money is worth 4% compounded monthly, what payment at
the end of each quarter will replace payments of P500.00 monthly?
4. Determine the present worth of an annual payment of
P2500.00 at the end of each year for 12 years at 8% compounded annually.
5. An employee obtained a loan of P10,000 at the rate of 6%
compounded annually in order to repair a house. How much must he pay
monthly to amortize the loan within a period of ten years?

MODULE 2: CONTINUOS COMPOUNDING, NOMINAL AND EFFECTIVE RATE OF

INTEREST and ORDINARY ANNUITY
6|PAGE
 6. An instructor plans to retire in exactly one year and want an
account that will pay him P25,000.00 a year for the next 15 years. Assuming a
6% annual effective interest rate, what is the amount he would need to
deposit now? (The fund will be depleted after 15 years)

MODULE 2: CONTINUOS COMPOUNDING, NOMINAL AND EFFECTIVE RATE OF

INTEREST and ORDINARY ANNUITY
7|PAGE