Equivalence Analysis using
Effective Interest Rates
Sean Piseth
Contemporary Engineering Economics, 4 th
edition, © 2007
Equivalence Calculations using Effective
Interest Rates
Step 1: Identify the payment period (e.g.,
annual, quarter, month, week, etc)
Step 2: Identify the interest period (e.g.,
annually, quarterly, monthly, etc)
Step 3: Find the effective interest rate that
covers the payment period.
Contemporary Engineering Economics, 4 th
edition, © 2007
Case I: When Payment Period is Equal to
Compounding Period
Step 1: Identify the number of compounding
periods (M) per year
Step 2: Compute the effective interest rate per
payment period (i)
i = r/M
Step 3: Determine the total number of payment
periods (N)
N = M ×(number of
years) Contemporary Engineering Economics, 4
th
edition, © 2007
Example 4.4: Calculating Auto Loan
Payments
Given:
MSRP = $20,870
Discounts & Rebates = $2,443
Net sale price = $18,427
Down payment = $3,427
Dealer’s interest rate = 6.25% APR
Length of financing = 72 months
Find: the monthly payment (A)
Contemporary Engineering Economics, 4 th
edition, © 2007
Solution:
Step 1: M = 12
Step 2: i = r/M = 6.25%/12 = 0.5208% per month
Step 3: N = (12)(6) = 72 months
Step 4: A = $15,000(A/P, 0.5208%,72) = $250.37
Contemporary Engineering Economics, 4 th
edition, © 2007
Dollars Up in Smoke
What three levels of smokers who bought
cigarettes every day for 30 years at $4.75 a
pack would have if they had instead banked
that money each week:
Level of smoker Would have had
1 pack a day $132,110
2 packs a day $264,220
3 packs a day $396,331
Note: Assumes constant price per pack, the money banked weekly and an
annual interest rate of 5.5%
Contemporary Engineering Economics, 4 th
edition, © 2007
Sample Calculation: One Pack per Day
Step 1: Determine the effective interest rate per
payment period.
Payment period = weekly
“5.5% interest compounded weekly”
i = 5.5%/52 = 0.10577% per week
Step 2: Compute the equivalent value at 30 years from now.
Weekly deposit amount
A = $4.75 x 7 = $33.25 per week
Total number of deposit periods
N = (52 weeks/yr.)(30 years)
= 1,560 weeks
F = $33.25 (F/A, 0.10577%, 1560)
= $132,110
Contemporary Engineering Economics, 4 th
edition, © 2007
Practice Problem
Suppose you drink a cup of Starbuck coffee ($3.00
a cup) on the way to work every morning for 30
years. If you put the money in the bank for the same
period, how much would you have, assuming your
accounts earns a 5% interest compounded daily.
NOTE: Assume you drink a cup of coffee every day
including weekends.
Contemporary Engineering Economics, 4 th
edition, © 2007
Solution
Payment period: Daily
Compounding period: Daily
5%
i 0.0137% per day
365
N 30 365 10, 950 days
F $3( F / A, 0.0137%,10950)
$76, 246
Contemporary Engineering Economics, 4 th
edition, © 2007
Case II: When Payment Periods Differ from Compounding
Periods
Step 1: Identify the following parameters
M = No. of compounding periods
K = No. of payment periods
C = No. of interest periods per payment period
Step 2: Compute the effective interest rate per payment
period
For discrete compounding
i [1 r / CK ] 1 C
For continuous compounding
i er / K 1
Step 3: Find the total no. of payment periods
N = K (no. of years)
Step 4: Use i and N in the appropriate equivalence formula
Contemporary Engineering Economics, 4 th
edition, © 2007
Discrete Case: Quarterly deposits with Monthly
compounding
Year 1 Year 2 Year 3
F=?
0 1 2 3 4 5 6 7 8 9 10 11 12
Quarters
A = $1,000
Step 1: M = 12 compounding periods/year
K = 4 payment periods/year
C = 3 interest periods per quarter
Step 2: i [1 0.12 /(3)(4)]3 1
3.030%
Step 3: N = 4(3) = 12
Step 4: F = $1,000 (F/A, 3.030%, 12)
= $14,216.24
Contemporary Engineering Economics, 4 th
edition, © 2007
Continuous Case: Quarterly deposits with Continuous
compounding
Year 1 Year 2 Year 3
F=?
0 1 2 3 4 5 6 7 8 9 10 11 12
Quarters
A = $1,000
Step 1: K = 4 payment periods/year
C = interest periods per quarter
Step 2:
ie0 .12 / 4
1
3.045% per quarter
Step 3: N = 4(3) = 12
Step 4: F = $1,000 (F/A, 3.045%, 12)
= $14,228.37
Contemporary Engineering Economics, 4 th
edition, © 2007
Practice Problem
A series of equal quarterly payments of
$5,000 for 10 years is equivalent to what
present amount at an interest rate of 9%
compounded
(a) quarterly
(b) monthly
(c) continuously
Contemporary Engineering Economics, 4 th
edition, © 2007
Solution
A = $5,000
1 2 40 Quarters
Contemporary Engineering Economics, 4 th
edition, © 2007
(a) Quarterly
Payment period :
A = $5,000
Quarterly
Interest Period:
0
Quarterly
1 2 40 Quarters
9%
i 2.25% per quarter
4
N 40 quarters
P $5, 000( P / A, 2.25%, 40)
$130,968
Contemporary Engineering Economics, 4 th
edition, © 2007
(b) Monthly
Payment period :
A = $5,000
Quarterly
Interest Period: Monthly
0
1 2 40 Quarters
9%
i 0.75% per month
12
i p (1 0.0075)3 2.267% per quarter
N 40 quarters
P $5, 000( P / A, 2.267%, 40)
$130,586
Contemporary Engineering Economics, 4 th
edition, © 2007
(c) Continuously
Payment period :
A = $5,000
Quarterly
Interest Period:
0
Continuously
1 2 40 Quarters
i e0.09 / 4 1 2.276% per quarter
N 40 quarters
P $5, 000( P / A, 2.276%, 40)
$130,384
Contemporary Engineering Economics, 4 th
edition, © 2007
A Decision Flow Chart on How to Compute the
Effective Interest Rate per Payment Period
Contemporary Engineering Economics, 4 th
edition, © 2007
Equivalence Calculations
with Continuous Payments
Lecture No.12
Chapter 4
Contemporary Engineering Economics
Copyright © 2006
Contemporry Engineering Economics, 4 th
edition, © 2007
Single-Payment Transactions with
Continuous Compounding – Future Worth
F P(1 i ) N
P(1 e r 1) N 0
N
Pe rN
Contemporary Engineering Economics, 4 th
edition, © 2007
Practice Problem
If you invest $1,000 in a
savings account that ia e 1 0.06
pays 6% annual 6.18%
interest compounded
continuously, what F $1,000( F / P,6.18%,3)
would be the balance at
the end of 3 years? $1,197.09
Contemporary Engineering Economics, 4 th
edition, © 2007
Single-Payment Transactions with Continuous Compounding –
Present Worth
N
P F (1 i )
N 0
F (1 e 1)
r
N
rN
Fe
P
Contemporary Engineering Economics, 4 th
edition, © 2007
Continuous-Funds Flow
P f (t )t e
t 0
rt
N
f (t )e rt dt
0
Contemporary Engineering Economics, 4 th
edition, © 2007
Summary of Interest Factors for Typical Continuous
Cash Flows with Continuous Compounding
Contemporary Engineering Economics, 4 th
edition, © 2007
Example 4.9 Comparison of Daily Flows and Daily
Compounding with Continuous Flows and Continuous
Compounding
Contemporary Engineering Economics, 4 th
edition, © 2007
Solution:
Daily Transaction:
F $200( F / A, 0.01644%, 455)
$200(472.4095)
$94, 482
The difference
Continuous Flow: between
f (t ) A, 0 t 1.25
the two methods
$200(365)
$73, 000 is only $277.
1.25
F
0
73, 000e 0.06 (1.25 t ) dt
e 0.075 1
$73, 000
0.06
$94, 759
Contemporary Engineering Economics, 4 th
edition, © 2007
