Lecture slides to accompany

Engineering Economy, 8th edition

Leland Blank, Anthony Tarquin

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 Chapter 4

Nominal and Effective Interest

Rates

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 LEARNING OUTCOMES
1. Understand interest rate statements

2. Use formula for effective interest rates

3. Determine interest rate for any time period

4. Determine payment period (PP) and

compounding period (CP) for equivalence
calculations

5. Make calculations for single cash flows

6. Make calculations for series and gradient cash

flows with PP CP

7. Perform equivalence calculations when PP CP

8. Use interest rate formula for continuous

compounding
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 Interest Rate Statements
Theterms
The terms‘nominal’
‘nominal’and
and‘effective’
‘effective’enter
enterinto
intoconsideration
consideration
whenthe
when theinterest
interestcompounded
compoundedperiod
periodisisless
lessthan
thanone
oneyear.
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
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the one year interest period.
 Understanding Interest Rate Terminology
A nominal interest rate (r) is obtained by multiplying an interest rate that is
expressed in a time period by the number of periods in a longer time period.
Nominal interest rate r is an interest rate that does no account for
compounding.
That is:
r interest rate per period x number of periods
It can be calculated for any time period longer than the time period stated

Example: If i 1% per month, nominal rate per year is

r (1)(12) 12% per year)

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.

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 Understanding Nominal Interest

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 Effective interest rate

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 More About Interest Rate Terminology
Thereare
There are33general
generalways
waystotoexpress
expressinterest
interestrates
ratesas
asshown
shownbelow
below

Sample Interest Rate Statements Comment

(1) i 2% per month When no compounding period
i 12% per year is given, rate is effective

(2) i 10% per year, comp’d semiannually When compounding period is given
i 3% per quarter, comp’d monthly and it is not the same as interest
period, it is nominal

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

i effective 4% per quarter, comp’d monthly and rate is specified as effective,
rate is effective over stated period

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 Nominal to Effective per CP relation

• Effective rate per CP=

• Example: r = 9% per year, compounded monthly find effective

rate per month?
m=12 , r= 9%, t= 1 year :
Effective interest per CP = 9%/12 = 0.75% per month(0.75% per
month, compounded monthly )
Note that,
r = 9% per year, compounded monthly is equal to r = 4.5% per 6 months,
compounded monthly.
Eff. Interest rate Per month = 4.5%/6= 0.75% per month.

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 Example: Effective rate Per CP

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 Effective For any Time period
Nominalrates
Nominal ratescan
canbe
beconverted
convertedinto
intoeffective
effectiverates
ratesfor
forany
anytime
timeperiod
period
viathe
via thefollowing
followingequation:
equation:

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
Example: Foran
aninterest
interestrate
rateofof1.2%
1.2%per
permonth,
month,determine
determinethe
thenominal
nominaland
and
effectiverates
effective rates(a)
(a)per
perquarter,
quarter,and
and(b)
(b)per
peryear
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 i /year (1.2)(12) 14.4% per year
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Effective i / year (1 + 0.144 / 12)12 1 15.39% per
 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

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
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 Single Amounts with PP > CP
Forproblems
For problemsinvolving
involvingsingle
singleamounts,
amounts,thethepayment
paymentperiod
period(PP)
(PP)isisusually
usuallylonger
longer
thanthe
than thecompounding
compoundingperiod
period(CP).
(CP).For
Forthese
theseproblems,
problems,there
thereare
areananinfinite
infinite
numberofofi iand
number andnncombinations
combinationsthat
thatcan
canbebeused,
used,with
withonly
onlytwo
tworestrictions:
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
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set n equal to the total number of those same time periods.
 Example PP>CP, Single payments

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 Solution

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 Series with PP ≥ CP
For series cash flows, first step is to determine relationship between PP and 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 discussed later

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 Examples: PP>CP, series payments

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 Example :

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 Solution

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 Continuous Compounding
Whenthe
When theinterest
interestperiod
periodisisinfinitely
infinitelysmall,
small,interest
interestisis
compoundedcontinuously.
compounded continuously. Therefore,
Therefore,PP PP CP
CPand
andmmincreases.
increases.

Take limit as m → to find the effective interest rate equation

Example: If a person deposits $500 into an account every 3 months at an

interest rate of 6% per year, compounded continuously, how much will be
in the account at the end of 5 years?
Solution: Payment Period: PP 3 months
Nominal rate per three months: r 6%/4
1.50%
Effective rate per 3 months: i e0.015 1
1.51% 𝐅 =𝟓𝟎𝟎( 𝐅 / 𝐀 ,𝟏.𝟓𝟏% ,𝟐𝟎)=$𝟏𝟏,𝟓𝟕𝟑
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 Summary of Important Points (1)

Must understand: interest period, compounding period, compounding

frequency, and payment
period

Always use effective rates in interest formulas

Interest rates are stated different ways; must know how to get effective rates

For single amounts, make sure units on i and n are the same

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 Summary of Important Points (2)

For uniform series with PP CP, find effective i over PP

For continuous compounding, use i er 1 to get effective rate

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