Effective Rate vs.

Stated Rated Time Value of Money

Under stated rate, for instance $ 1,000 at a rate of interest of 13 % is compounded semi-annually which fetches $ 1,134.60 towards the end of the year. This implies that $ 1,000 grows at the rate of 13.42 percent per annum and this rate of interest (13.42 %) is called the effective interest rate the rate of interest under annual compounding which generates the same outcome as that created by an interest rate of 13 % under semi-annual compounding.

The general association amid the effective interest rate and the stated annual interest rate is as below. Effective Interest Rate = (1 + Stated Annual Interest Rate / m) ^ m 1
Where, m is the frequency of compounding per year.

Illustration:
Let us assume a bank offers 13 % stated annual interest rate. What will be the effective interest rate when compounding is done quarterly, semi-annually and annually?
Effective interest rate with quarterly compounding = ((1 + (0.13 / 4)) ^ 4) 1 = 0.1364 Effective interest rate with semi-annual compounding = ((1 + (0.13 / 2)) ^ 2) 1 = 0.1342

Illustration:
Effective interest rate with annual compounding = ((1 + (0.13 / 1)) ^ 1) 1 = 0.13

When compounding becomes continuous the effective interest rate is expressed as below: Effective interest rate = e ^ r 1 Here, r is the stated interest rate and e is the base of logarithm.

The below given are few examples of compounding frequency and effective interest rate
Frequency Daily Monthly Weekly Continuous Stated Interest Rate ( % ) 13 % 13 % 13 % 13 % ( M ) Frequency of Compounding 365 days 12 months 52 weeks Formula Rate ( % ) (( 1 + ( 0.13 / 365 )) ^ 365 ) 1 (( 1 + ( 0.13 / 12 )) ^ 12 1 (( 1 + ( 0.13 / 52 )) ^ 52 ) 1 ( e ^ 0.13 ) - 1, e = 2.71828 Effective Interest Rate 13.88 13.80 13.86 13.8828

Shorter Discounting Periods:

From time to time cash flows have to be discounted more often than once every year semi-annually, quarterly, monthly or daily. As in the case of intra year compounding, the shorter discounting period entails that
(i) the number of periods in the investigation augments and (ii) the discount rate pertinent per period diminishes. The universal formula for computing the present value in the case of shorter discounting period is as below.

Shorter Discounting Periods:

P V = F V n (1 / (1 + (r / m))) ^ m n Where PV is denoted as the present value, FVn is the cash flow after n years, m is the number of times per year discounting is done and r is the annual discount rate.

More Info: Tutorsonnet