Chapter Summary 117

Solution
Figure 4–10 shows the cash flows, rates for each year, and the equivalent P and A. Equa-
tion [4.12] is used to calculate P. Since for both years 1 and 2 the net profit is $70,000 and the
annual rate is 7%, the PA factor can be used for these 2 years only.
P  [70(PA,7%,2)  35(PF,7%,2)(PF,9%,1)
 25(PF,7%,2)(PF,9%,1)(PF,10%,1)](1000)
 [70(1.8080)  35(0.8013)  25(0.7284)](1000)
 $172,816 [4.14]
$70,000

A=?
$35,000
$25,000

0 0
1 2 3 4 1 2 3 4 Year

i = 7%
7% 7% 9% 10%
i = 7%
i = 9%
i = 10%

P=? $172,816

Figure 4–10
Equivalent P and A values for varying interest rates, Example 4.14.

To determine an equivalent annual series, substitute the symbol A for all net profit values
on the right side of Equation [4.14], set it equal to P  $172,816, and solve for A. This
equation accounts for the varying i values each year. See Figure 4–10 for the cash flow diagram
transformation.
$172,816  A[(1.8080)  (0.8013)  (0.7284)]  A[3.3377]
A  $51,777 per year

Comment
If the average of the four annual rates, that is, 8.25% is used, the result is A  $52,467. This is
a $690 per year overestimate of the equivalent annual net profit.

When there is a cash flow in year 0 and interest rates vary annually, this cash flow must be
included to determine P. In the computation for the equivalent uniform series A over all years,
including year 0, it is important to include this initial cash flow at t  0. This is accomplished by
inserting the factor value for (PF,i0,0) into the relation for A. This factor value is always 1.00. It
is equally correct to find the A value using a future worth relation for F in year n. In this case, the
A value is determined using the FP factor, and the cash flow in year n is accounted for by includ-
ing the factor (FP,in,0)  1.00.

CHAPTER SUMMARY
Since many real-world situations involve cash flow frequencies and compounding periods other
than 1 year, it is necessary to use nominal and effective interest rates. When a nominal rate r is
stated, the effective interest rate i per payment period is determined by using the effective interest
rate equation.
Effective i  ( 1  —
m)  1
r m

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 118 Chapter 4 Nominal and Effective Interest Rates

The m is the number of compounding periods (CP) per interest period. If interest compounding
becomes more and more frequent, then the length of a CP approaches zero, continuous com-
pounding results, and the effective i is er  1.
All engineering economy factors require the use of an effective interest rate. The i and n val-
ues placed in a factor depend upon the type of cash flow series. If only single amounts (P and F)
are present, there are several ways to perform equivalence calculations using the factors. How-
ever, when series cash flows (A, G, and g) are present, only one combination of the effective rate
i and number of periods n is correct for the factors. This requires that the relative lengths of PP
and CP be considered as i and n are determined. The interest rate and payment periods must have
the same time unit for the factors to correctly account for the time value of money.
From one year (or interest period) to the next, interest rates will vary. To accurately perform
equivalence calculations for P and A when rates vary significantly, the applicable interest rate
should be used, not an average or constant rate.

PROBLEMS
Nominal and Effective Rates Given Interest Rate Desired Interest Rate

4.1 From the interest statement 18% per year, com- 1% per month Nominal rate per year
3% per quarter Nominal rate per 6 months
pounded monthly, determine the values for interest
2% per quarter Nominal rate per year
period, compounding period, and compounding
0.28% per week Nominal rate per quarter
frequency. 6.1% per 6 months Nominal rate per 2 years
4.2 From the interest statement 1% per month, deter-
mine the values for interest period, compounding 4.8 What nominal interest rate per year is equivalent to
period, and compounding frequency. 11.5% per year, compounded monthly?

4.3 Determine the number of times interest would be 4.9 For a Federal Credit Union that offers an interest
compounded in 6 months from the interest state- rate of 8% per year, compounded quarterly, deter-
ments (a) 18% per year, compounded monthly, mine the nominal rate per 6 months.
(b) 1% per month, and (c) 2% per quarter.
4.10 The Second National Bank of Fullertum advertises
4.4 For an interest rate of 1% per 2 months, determine an APR of 14% compounded monthly for student
the number of times interest would be compounded loans. Determine the APY. Show hand and spread-
in (a) 2 months, (b) two semiannual periods, and sheet solutions.
(c) 3 years.
4.11 For an effective annual rate ia of 15.87% com-
4.5 Identify the compounding period for the following pounded quarterly, determine (a) the effective
interest statements: (a) 3% per quarter; (b) 10% quarterly rate and (b) the nominal annual rate.
per year, compounded semiannually; (c) nominal (c) What is the spreadsheet function to find the
7.2% per year, compounded monthly; (d) effective nominal annual rate above?
3.4% per quarter, compounded weekly; and (e) 2%
per month, compounded continuously. 4.12 High-tech companies such as IBM, AMD, and
Intel have been using nanotechnology for several
4.6 Identify the following interest rate statements as years to make microchips with faster speeds while
either nominal or effective: (a) 1.5% per month, using less power. A less well-known company in
compounded daily; (b) 17% per year, compounded the chip business has been growing fast enough
quarterly; (c) effective 15% per year, compounded that the company uses a minimum attractive rate of
monthly; (d) nominal 0.6% per month, com- return of 60% per year. If this MARR is an effec-
pounded weekly; (e) 0.3% per week, compounded tive annual rate compounded monthly, determine
weekly; and (f) 8% per year. the effective monthly rate.

4.7 Convert the given interest rates in the left-hand 4.13 An interest rate of 21% per year, compounded
column into the nominal rates listed in the right- every 4 months, is equivalent to what effective rate
hand column. (Assume 4 weeksmonth.) per year? Show hand and spreadsheet solutions.

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 Problems 119

4.14 An interest rate of 8% per 6 months, compounded place in 3 years, how much will the company have
monthly, is equivalent to what effective rate per in its investment set-aside account? Assume the
quarter? company can achieve a rate of return of 12% per
year, compounded quarterly.
4.15 A small company that makes modular bevel gear
drives with a tight swing ratio for optimizing pallet 4.23 Wheeling-Pittsburgh Steel is investigating whether
truck design was told that the interest rate on a it should replace some of its basic oxygen furnace
mortgage loan would be an effective 4% per quar- equipment now or wait to do it later. The cost
ter, compounded monthly. The owner was con- later (i.e., 3 years from now) is estimated to be
fused by the terminology and asked you to help. $1,700,000. How much can the company afford to
What are (a) the APR and (b) the APY? spend now, if its minimum attractive rate of return
is 1.5% per month?
4.16 In ‘N Out Payday Loans advertises that for a fee of
only $10, you can immediately borrow up to $200 4.24 How much can Wells Fargo lend to a developer
for one month. If a person accepts the offer, what who will repay the loan by selling 6 view lots at
are (a) the nominal interest rate per year and $190,000 each 2 years from now? Assume the
(b) the effective rate per year? bank will lend at a nominal 14% per year, com-
pounded semiannually.
4.17 A government-required truth-in-lending document
showed that the APR was 21% and the APY was 4.25 How much will be in a high-yield account at the
22.71%. Determine the compounding frequency at National Bank of Arizona 12 years from now if
which the two rates are equivalent. you deposit $5000 now and $7000 five years from
now? The account earns interest at a rate of 8% per
4.18 Julie has a low credit rating, plus she was fur- year, compounded quarterly.
loughed from her job 2 months ago. She has a new
job starting next week and expects a salary to start 4.26 Loadstar Sensors is a company that makes load
again in a couple of weeks. Since she is a little force sensors based on capacitive sensing technol-
short on money to pay her rent, she decided to bor- ogy. The company wants to have $28 million for a
row $100 from a loan company, which will charge plant expansion 4 years from now. If the company
her only $10 interest if the $110 is paid no more has already set aside $12 million in an investment
than 1 week after the loan is made. What are the account for the expansion, how much more must
(a) nominal annual and (b) effective annual inter- the company add to the account next year (i.e.,
est rates that she will pay on this loan? 1 year from now) so that it will have the $28 mil-
lion 4 years from now? The account earns interest
Equivalence When PP ⱖ CP at 12% per year, compounded quarterly.
4.19 Assume you deposit 25% of your monthly check
4.27 A structural engineering consulting company is
of $5500 into a savings account at a credit union
examining its cash flow requirements for the next
that compounds interest semiannually. (a) What
6 years. The company expects to replace office
are the payment and compounding periods? (b) Is
machines and computer equipment at various
the payment period greater than or less than the
times over the 6-year planning period. Specifi-
compounding period?
cally, the company expects to spend $21,000 two
4.20 Interest is compounded quarterly, and single- years from now, $24,000 three years from now,
payment cash flows (that is, F and P) are separated and $10,000 five years from now. What is the pres-
by 5 years. What must the compounding period be ent worth of the planned expenditures at an interest
on the interest rate, if the value of n in the PF or rate of 10% per year, compounded semiannually?
FP equation is (a) n  5, (b) n  20, or (c) n  60?
4.28 Irvin Aerospace of Santa Ana, California, was
4.21 When interest is compounded quarterly and a awarded a 5-year contract to develop an advanced
uniform series cash flow of $4000 occurs every space capsule airbag landing attenuation system
6 months, what time periods on i and n must be for NASA’s Langley Research Center. The com-
used? pany’s computer system uses fluid structure inter-
action modeling to test and analyze each airbag
4.22 Pinpoint Laser Systems is planning to set aside design concept. What is the present worth of the
$260,000 now for possibly replacing its 4-pole, contract at 16% per year, compounded quarterly, if
38-MW synchronous motors when it becomes the quarterly cost in years 1 through 5 is $2 million
necessary. If the replacement is expected to take per quarter?

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 120 Chapter 4 Nominal and Effective Interest Rates

4.29 Heyden Motion Solutions ordered $7 million 4.34 NRG Energy plans to construct a giant solar plant
worth of seamless tubes for its drill collars from in Santa Teresa, New Mexico, to supply electricity
the Timken Company of Canton, Ohio. (A drill to West Texas Electric. The plant will have 390,000
collar is the heavy tubular connection between a heliostats to concentrate sunlight onto 32 water
drill pipe and a drill bit.) At 12% per year, com- towers to generate steam. It will provide enough
pounded semiannually, what is the equivalent uni- power for 30,000 homes. If the company spends
form cost per semiannual period over a 5-year $28 million per month for 2 years in constructing
amortization period? the plant, how much will the company have to
make each month in years 3 through 22 (that is,
4.30 In 2010, the National Highway Traffic Safety Ad- 20 years) to recover its investment plus 18% per
ministration raised the average fuel efficiency stan- year, compounded monthly?
dard to 35.5 miles per gallon (mpg) for cars and
light trucks by the year 2016. The rules will cost 4.35 Many college students have Visa credit cards that
consumers an average of $926 extra per vehicle in carry an interest rate of “simple 24% per year”
the 2016 model year. Assume Yolanda will pur- (that is, 2% per month). When the balance on
chase a new car in 2016 and plans to keep it for such a card is $5000, the minimum payment is
5 years. How much will the monthly savings in the $110.25.
cost of gasoline have to be to recover Yolanda’s (a) What is the amount of interest in the first
extra cost? Use an interest rate of 0.75% per month. payment?
(b) How long will it take, in months, to pay off
4.31 Fort Bliss, a U.S. Army military base, contributed the balance, if the cardholder continues to
$3.3 million of the $87 million capital cost for a make payments of $110.25 per month and
desalting plant constructed and operated by El Paso adds no other charges to the card?
Water Utilities (EPWU). In return, EPWU agreed
to sell water to Fort Bliss at $0.85 per 1000 gallons 4.36 Bart is an engineering graduate who did not take
for 20 years. If the army base uses 200 million gal- the engineering economy elective during his B.S.
lons of water per month, what is the Army’s cost degree course work. After working for a year or so,
per month for water? The $3.3 million capital cost he found himself in financial trouble, and he bor-
is amortized at an interest rate of 6% per year, rowed $500 from a friend in the finance depart-
compounded monthly. ment at his office. Bart agreed to repay the loan
principal plus $75 interest 1 month later. The two
4.32 Beginning in 2011, city hall, administrative of- got separated doing different jobs, and 1 year went
fices, and municipal courts in the city of El Paso, by. The friend e-mailed Bart after exactly 1 year
Texas, will go on a 10 hourday, 4-day workweek and asked for the loan repayment plus the interest
from the beginning of May through the end of Sep- with monthly compounding, since Bart had made
tember. The shortened workweek will affect 25% no effort to repay the loan during the year.
of the city’s 6100 employees and will save $42,600 (a) What does Bart now owe his friend? (b) What
per month for those 5 months, because of reduced effective annual interest rate did Bart pay on this
fuel, utility, and janitorial expenses. If this work $500 loan?
schedule continues for the next 10 years, what is
the future worth of the savings at the end of that 4.37 AT&T announced that the early termination fee for
time (i.e., end of year 2020)? Use an interest rate smart phones will jump from $175 to $375. The
of 0.5% per month. fee will be reduced by $10 each month of the
2-year contract. Wireless carriers justify the fees
4.33 In October 2009, Wal-Mart started selling caskets by pointing out that the cost of a new phone is
on its website that undercut many funeral homes. heavily discounted from what the carrier pays the
Prices ranged from $999 for steel models such as manufacturer. Assume AT&T pays $499 for an
Dad Remembered to $3199 for the Sienna Bronze iPhone that it sells for $199. How much profit
casket. Part of the business model is to get people would the company have to make each month (i.e.,
to plan ahead, so the company is allowing people prior to the termination), if it wanted to make a rate
to pay for the caskets over a 12-month period with of return of 1.5% per month on its $300 invest-
no interest. An individual purchased a Sienna ment in a customer who terminates the contract
Bronze casket and made 12 equal monthly pay- after 12 months?
ments (in months 1 through 12) at no interest. How
much did this person save each month compared to 4.38 What is the future worth of a present cost of
another person who paid an interest rate of 6% per $285,000 to Monsanto, Inc. 5 years from now at an
year, compounded monthly? interest rate of 2% per month?

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 Problems 121

4.39 Environmental recovery company RexChem Part- Lee antiscalant) for use at its nanofiltration water
ners plans to finance a site reclamation project conditioning plant. The cost of the pumps was
that will require a 4-year cleanup period. The $950 each. If the chemical cost is $11 per day,
company plans to borrow $3.6 million now. How determine the equivalent cost per month at an in-
much will the company have to get in a lump-sum terest rate of 12% per year, compounded monthly.
payment when the project is over in order to earn Assume 30 days per month and a 3-year pump
24% per year, compounded quarterly, on its in- life.
vestment?
4.46 Income from recycling paper and cardboard at the
4.40 For the cash flows shown below, determine the U.S. Army's Fort Benning Maneuver Center has
equivalent uniform worth in years 1 through 5 at an averaged $3000 per month for 2½ years. What is
interest rate of 18% per year, compounded monthly. the future worth of the income (after the 2½ years)
at an interest rate of 6% per year, compounded
Year 1 2 3 4 5
quarterly? Assume there is no interperiod com-
Cash Flow, $ 200,000 0 350,000 0 400,000 pounding.
4.41 For the cash flow diagram shown, solve for F, 4.47 The Autocar E3 refuse truck has an energy re-
using an interest rate of 1% per month. covery system developed by Parker Hannifin
F=? LLC that is expected to reduce fuel consumption
by 50%. Pressurized fluid flows from carbon
i = 1% per month fiber-reinforced accumulator tanks to two hydro-
static motors that propel the vehicle forward.
0 1 2 3 4 5 6 7 8 Years (The truck recharges the accumulators when it
brakes.) The fuel cost for a regular refuse truck is
$900 per month. How much can a private waste-
hauling company afford to spend now on the
$30 $30 $30 $30 $30 $30
recovery system, if it wants to recover its invest-
ment in 3 years plus a return of 14% per year,
compounded semiannually? Assume no interpe-
$50 $50 $50 riod compounding.

4.42 According to the Government Accountability Of- Continuous Compounding

fice (GAO), if the U.S. Postal Service does not 4.48 What effective interest rate per year is equal to
change its business model, it will lose $480 million 1.2% per month, compounded continuously? Show
next month and $500 million the month after that, hand and spreadsheet solutions.
and the losses will increase by $20 million per
month for the next 10 years. At an interest rate of 4.49 What effective interest rate per quarter is equal to
0.25% per month, what is the equivalent uniform a nominal 1.6% per month, compounded con-
amount per month of the losses through year 10? tinuously?
4.43 Equipment maintenance costs for manufacturing 4.50 What nominal rate per month is equivalent to an
explosion-proof pressure switches are projected to effective 1.3% per month, compounded continu-
be $100,000 in year 1 and increase by 4% each ously?
year through year 5. What is the present worth of
the maintenance costs at an interest rate of 10% 4.51 Companies such as GE that have huge amounts of
per year, compounded quarterly? cash flow every day base their financial calculations
on continuous compounding. If the company wants
Equivalence When PP ⬍ CP to make an effective 25% per year, compounded
continuously, what nominal daily rate of return has
4.44 If you deposit $1000 per month into an investment to be realized? Assume 365 days per year.
account that pays interest at a rate of 6% per year,
compounded quarterly, how much will be in the 4.52 U.S. Steel is planning a plant expansion that is ex-
account at the end of 5 years? There is no interpe- pected to cost $13 million. How much money must
riod compounding. the company set aside now in a lump-sum invest-
ment to have the money in 2 years? Capital funds
4.45 Freeport McMoran purchased two model MTVS earn interest at a rate of 12% per year, compounded
peristaltic pumps (to inject sulfuric acid and King continuously.

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 122 Chapter 4 Nominal and Effective Interest Rates

4.53 Periodic outlays for inventory control software at nanowires can be extruded by blasting the carbon
Baron Chemicals are expected to be $150,000 nanotubes with an electron beam. If Gentech Tech-
immediately, $200,000 in 1 year, and $350,000 in nologies plans to spend $1.7 million in year 1,
2 years. What is the present worth of the costs at $2.1 million in year 2, and $3.4 million in year 3 to
an interest rate of 10% per year, compounded develop the technology, determine the present
continuously? worth of the investments in year 0, if the interest
rate in year 1 is 10% and in years 2 and 3 it is 12%
Varying Interest Rates per year.
4.54 Many small companies use accounts receivable as 4.57 Find (a) the present worth P, and (b) the equiva-
collateral to borrow money for continuing opera- lent uniform annual worth A for the cash flows
tions and meeting payrolls. If a company borrows shown below.
$300,000 now at an interest rate of 1% per month,
but the rate changes to 1.25% per month after P=?
4 months, how much will the company owe at the
end of 1 year?
i = 10% i = 14%
4.55 The maintenance cost for furnaces at a copper
smelting plant have been constant at $140,000 per 0 1 2 3 4 5 6 7 8 Year
year for the past 5 years. If the interest rate was 8%
per year for the first 3 years and then it increased to
10% in years 4 and 5, what is the equivalent future
worth (in year 5) of the maintenance cost? Show
$100 $100 $100 $100 $100
hand and spreadsheet solutions.

4.56 By filling carbon nanotubes with miniscule wires

$160 $160 $160
made of iron and iron carbide, incredibly thin

ADDITIONAL PROBLEMS AND FE EXAM REVIEW QUESTIONS

4.58 The term annual percentage rate is the same as: (c) 6.0% per quarter, compounded continuously
(a) Effective rate (d) 9% per 6 months
(b) Nominal rate
(c) Annual percentage yield 4.62 An effective 12.68% per year, compounded monthly,
(d) All of the above is the closest to:
(a) 12% per year
4.59 An interest rate is an effective rate under all of the (b) 12% per year, compounded annually
following conditions, except when: (c) 1% per month
(a) The compounding period is not stated (d) 1% per month, compounded annually
(b) The interest period and compounding period
are the same 4.63 For an interest rate of 2% per month, the effective
(c) The interest statement says that the interest semiannual interest rate is:
rate is effective (a) 2.02%
(d) The interest period is shorter than the com- (b) 12.005%
pounding period (c) 12.31%
(d) 12.62%
4.60 An interest rate of nominal 12% per year, com-
pounded weekly, is: 4.64 If you make quarterly deposits for 3 years into an
(a) An effective rate per year account that compounds interest at 1% per month,
(b) An effective rate per week the value of n in the FA factor that will determine
(c) A nominal rate per year F at the end of the 3-year period is:
(d) A nominal rate per week (a) 3 (b) 12
(c) 36 (d) None of these
4.61 An interest rate of 1.5% per month, compounded
continuously, is the same as:
(a) An effective 1.5% per month
(b) 4.5% per quarter, compounded continuously

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 Additional Problems and FE Exam Review Questions 123

4.65 Identify the following interest rates as nominal or F=?

i = 1% per month
effective.
Rate 1: 1.5% per quarter
Rate 2: 1.5% per quarter, compounded 0 1 2 3 4 5 6 7 8 9 10 11 12 Quarter
monthly
1 2 3 Year
(a) Both are nominal rates.
(b) Rate 1 is nominal and rate 2 is effective. $400 $400
(c) Rate 1 is effective and rate 2 is nominal. $420
(d) Both are effective. $440

$460
4.66 In solving uniform series problems, n in the stan-
dard factor notation equation is equal to the $480
number of arrows (i.e., cash flows) in the original $500
cash flow diagram when:
(a) The payment period (PP) is longer than the
compounding period (CP).
(b) The compounding period is equal to the pay- 4.70 A small company plans to spend $10,000 in year 2
ment period. and $10,000 in year 5. At an interest rate of effective
(c) Both (a) and (b) are correct. 10% per year, compounded semiannually, the equa-
(d) The compounding period is longer than the tion that represents the equivalent annual worth A in
payment period. years 1 through 5 is:
(a) A  10,000(PF,10%,2)(AP,10%,5)
4.67 An engineer who is saving for her retirement plans  10,000(AF,10%,5)
to deposit $500 every quarter, starting one quarter (b) A  10,000(AP,10%,4)  10,000(AF,10%,5)
from now, into an investment account. If the ac- (c) A  10,000(PF,5%,2)(AP,5%,10)
count pays interest at 6% per year, compounded  10,000(AF,5%,10)
semiannually, the total she will have at the end of (d) A  [10,000(FP,10%,5)
25 years is closest to:  10,000](AF,10%,5)
(a) $50,000 (b) $56,400
(c) $79,700 (d) $112,800 4.71 Assume you make monthly deposits of $200 start-
ing one month from now into an account that pays
4.68 A company that makes flange-mount, motorized ro- 6% per year, compounded semiannually. If you
tary potentiometers expects to spend $50,000 for a want to know the total after 4 years, the value of n
certain machine 4 years from now. At an interest rate you should use in the FA factor is:
of 12% per year, compounded quarterly, the present (a) 2 (b) 4 (c) 8 (d) 12
worth of the machine’s cost is represented by the fol-
lowing equation: 4.72 The cost of replacing part of a cell phone video-
(a) P  50,000(PF, 3%, 16) chip production line in 6 years is estimated to be
(b) P  50,000(PF, effective i6 months, 8) $500,000. At an interest rate of 14% per year,
(c) P  50,000(PF, effective iyear, 4) compounded semiannually, the uniform amount
(d) Any of the above that must be deposited into a sinking fund every
6 months is closest to:
4.69 For the cash flow diagram shown, the unit of the (a) $21,335 (b) $24,825
payment period (PP) is: (c) $27,950 (d) $97,995
(a) Months (b) Quarters
(c) Semiannual (d) Years

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