NE 364
Engineering Economy
Lecture 7
Money-Time Relationships and Equivalence
(Part 5: Nominal and Effective Interest Rates)
NE 364 Engineering Economy
Effective Interest Rate
Let
r be the nominal, annual interest rate and
M the number of compounding periods per year.
We can find, ie, the effective interest by using the
formula below.
NE 364 Engineering Economy
The number of compounding periods per year
r compounded monthly m=12
r compounded bimonthly m=6
r compounded semiannually m=2
r compounded quarterly m=4
r compounded weekly m=52
r compounded daily m=365
r compounded yearly m=1
NE 364 Engineering Economy
Example
"12% compounded semiannually.”
Here the annual rate of interest is known as the
nominal rate, 12% in this case. A nominal interest
rate is represented by r.
But the actual (or effective) annual rate i on the
principal is not 12%, but something greater,
because compounding occurs twice during the year.
NE 364 Engineering Economy
Examples
For an 18% nominal rate, compounded quarterly, the
effective annual interest is.
For a 7% nominal rate, compounded monthly, the
effective annual interest is.
NE 364 Engineering Economy
Example
Suppose that a $100 lump-sum amount is invested
for 10 years at a nominal interest rate of 6%
compounded quarterly. How much is it worth at the
end of the 10th year?
NE 364 Engineering Economy
Solution
r= 6%
m= 4
0.06 4
ieff/year= (1+ 4
) -1= 6.14%
F= P(f/p, 6.14%, 10)
F=$100 * (1 + 0.0614)10 = $181.40
NE 364 Engineering Economy
Example 2
How much money will be in an account in 5 years if $10,000
is deposited now with interest rate of:
12% compounded monthly.
ieff/year = (1 + 0.12/12)12 –1 = 12.683%
F = 10,000(F/P,12.683%,5)
years i and n must always
= $18,167 effective i per year
have same time units
NE 364 Engineering Economy
Effective interest rate.
𝑟
i eff/ same compounding period = 𝑚
Suppose that a $2000 lump-sum amount is invested for 15
months at a nominal interest rate of 6% compounded
monthly. How much is it worth at the end of the 15th month.
ieff/month= 0.06
12 2
1
= %
1
F= P(f/p, 2%, 15)
F= 2000*( 1.0777)= $2,155.4
NE 364 Engineering Economy
Example
Stan Moneymaker has a bank loan for $10,000 to pay for his
new truck. This loan is to be repaid in equal end-of-month
installments for five years with a nominal interest rate of 12%
compounded monthly. What is the amount of each payment?
NE 364 Engineering Economy
NE 364 Engineering Economy
Solve 1
What extra semiannual expenditure for five years
would be justified for the maintenance of a
machine in order to avoid an overhaul costing
$3,000 at the end of five years? Assume nominal
interest at 8% compounded semiannually.
Draw a cashflow.
NE 364 Engineering Economy
Solve 2
Determine the current amount of money that must
be invested at 12% nominal interest, compounded
monthly, to provide an annuity of $10,000 (per
year) for 6 years, starting 12 years from now. The
interest rate remains constant over this entire
period of time. Draw a cashflow
NE 364 Engineering Economy
Thank you!
NE 364 Engineering Economy
