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MS-291: Engineering Economy


(3 Credit Hours)

ARITHMETIC GRADIENT
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Arithmetic Gradient Factors


(P/G, A/G)
• Cash flows that increase or decrease by a constant amount
are considered arithmetic gradient cash flows.

• The amount of increase (or decrease) is called the gradient


$2000 Gradient
$175 $1500 series
$150 $1000 could be
$125
$100 $500 both: cash
inflow (as
given
0 1 2 3 4 0 1 2 3 4 here) or
Outflows
G = $25 G = -$500
Base = $100 Base = $2000

Cash Flow Formula CFn = base amount + (n-1)G

Arithmetic Gradient Factors


(P/G, A/G)

• When we have a “Gradient” Series we


cannot apply Single Amount Present
Worth/Future Worth factors or Uniform
Series factors

• We have to use a different methodology to


address problems related to gradient cash
flows.
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Solving Arithmetic Gradient


related problems

Present value of the Arithmetic Gradient series can be


calculated as follows:
1. Find the gradient and base
2. Cash flow diagram maybe helpful if you draw it
3. Break the gradient series into a Uniform series and a
Gradient Series as shown on next slide
4. The formula for calculating present value of the
Arithmetic Gradient series is as follows;

PT = PA + PG
5. Calculate PA and PG and use the above formula to
get the present value of the Arithmetic Gradient

Arithmetic Gradient Factors


(P/G, A/G)
• The base amount is “A” and the “Gradient is “G” in the
following graph
Cash Flow Formula CFn = base amount + (n-1)G
Important!!!
PG series start
A+(n-1) G with year 2
A+3G
(n-1)G
A+2G
3G
A+G 2G
A A A A A A
G
= + 0

0 1 2 3 4 n 0 1 2 3 4 n
0 1 2 3 4 n

PT = PA + PG
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Arithmetic Gradient Factors


(P/G, A/G)

PT = PA + PG
• PA = A(P/A, i, n) or Uniform Series Present worth
Factor

• PG = G(P/G, i, n) or Arithmetic Gradient Present


Worth Factor … you can use table for it too.

• Alternatively, PG can also be calculated by


following formula
G  (1  i ) n  in  1 
G  (1  i ) n  1 n 

PG 
PG   Or i  i 2 (1  i ) n 
i  i (1  i ) n   
 ( 1  i)n 

Arithmetic Gradient Factors


(P/G, A/G)
Equivalent cash flows:
$175
$150
$125 $75
$100 $100 $50
$25
=> +
0 1 2 3 4
0 1 2 3 4 0 1 2 3 4
Note: Annuity series (PA) Note: the gradient series
G = $25 (PG) by convention starts
starts from year 1.
Base = $100 in year 2.

PT = PA + PG
G  (1  i )n  1 n 
PG    
i  i (1  i )n (1  i )n 
$P = $100(P/A,i,4) + $25(P/G,i,4)

Where PA = Present worth uniform series (P/A, i,n) and PG = present worth of the gradient series (P/G,i, n)
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Example (Problem 2.25)


Profits from recycling paper, cardboard, aluminium,
and glass at a liberal arts college have increased at a
constant rate of $1100 in each of the last 3 years.
If this year’s profit (end of year 1) is expected to be
$6000 and the profit trend continues through year 5,
(a) what will the profit be at the end of year 5 and
(b) what is the present worth of the profit at an interest
rate of 8% per year?

G = $1100, Base = $6000

Example (Problem 2.25)


(a) what will the profit be at the end of year 5 &
(b) what is the present worth of the profit at an interest rate of 8% per
year?

G = $1100 Base = $6000


$4400
$10400 $6000 $3300
$2200
$9300 $1100
$8200 => +
$7100 0 1 2 3 4 5
0 1 2 3 4 5
$6000
PT = PA + PG
0 1 2 3 4 5 P = A(P/A, i, n) + G(P/G, i, n)
Find the cash flows as follows: P = 6000(P/A, 8%, 5) + 1100(P/G, 8%, 5)
CF = Base + G(n-1) P=
CF1 = 6000 + 1100(1-1)= 6000
6000(3.9927) + 1100(7.3724)
CF2 = 6000 + 1100(2-1)= 7100
CF3 = 6000 + 1100(3-1)= 8200
CF4 = 6000 + 1100(4-1)= 9300 P = 32066
CF5 = 6000 + 1100(5-1)= 10400
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Practice Question: 5 minutes


Neighboring parishes in Louisiana have agreed to pool
road tax resources already designated for bridge
refurbishment. At a recent meeting, the engineers
estimated that a total of $500,000 will be deposited at
the end of next year into an account for the repair of
old and safety-questionable bridges throughout the area.
Further, they estimate that the deposits will increase
by $100,000 per year for only 9 year thereafter, then
cease. Determine the equivalent: present worth, if public
funds earn at a rate of 5% per year.
5% Uniform Series Factors Athematic Gradient
n Sinking Compound Capital Present Gradient Gradient
Fund Amount Recovery Worth Present Worth Uniform
(A/F) (F/A) (A/P) (P/A) (P/G) Series (A/G)
9 0.09069 11.0266 0.14069 7.1078 26.1268 3.6758
10 0.07950 12.5779. 0.12950 7.7217 31.6520 4.0991

Solution

• Base = 500,000 PT = PA + PG
• Gradient = 100,000 PT = 500(P/A,5%,10) + 100(P/G,5%,10)
• Taking units in 1000 = 500(7.7217) + 100(31.6520)
=$7026.05 or ….. ($7,026,050)
• Base = 500
• Gradient =100 0 1 2 3 4 5 6 7 8 9 10

• i= 5%
$500
• n=1+9 = 10 $600
$700
$800
$900
$1000 $1100
$1200
$1300
$1400
P=?
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…. What about A/G or F/G?

Arithmetic Gradient Uniform


Series Factor (A/G)

• Similar procedure as done for Arithmetic Gradient Present


worth Factor
• Following formula:

AT = AA + AG
AA = A (Annual Worth) Given as base value of G series and AG = G(A/G, i, n)

AG can be get from 1


factor tables or through = −
given formula in box (1 + ) −1
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Using Factor Tables

Example: A/G factor


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Example: A/G Factor

Neighboring parishes in Louisiana have agreed to pool


road tax resources already designated for bridge
refurbishment. At a recent meeting, the engineers
estimated that a total of $500,000 will be deposited at
the end of next year into an account for the repair of
old and safety-questionable bridges throughout the area.
Further, they estimate that the deposits will increase
by $100,000 per year for only 9 year thereafter, then
cease.
Determine the equivalent: Annual series amount, if
public funds earn at a rate of 5% per year.

Solution
AT = AA + AG
• Base = 500,000
AT = 500 + 100(A/G,5%,10)
• Gradient = 100,000 = 500 + 100(4.0991)
• Taking units in 1000 =$909.91 or ….. ($909,910)

• Base = 500 0 1 2 3 4 5 6 7 8 9 10

• Gradient =100
• i= 5% $500
$600
$700
• n=1+9 = 10 $800
$900
$1000 $1100
$1200
$1300
$1400
0 1 2 3 4 5 6 7 8 9 10

A= $909,910
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Arithmetic Gradient Future


Worth Factor (F/G)
• Another factor in “Gradient family” is “Future” worth
of an Arithmetic Gradient series (F/G)
• It can be obtained by multiply (P/G) and (F/P) factors
1 (1 + ) −1 × =
/ = −

No factor table values is available so only formula can be use for calculating “F/G” factor

Note: To get future value of Arithmetic Gradient …. We do not need to


divide the gradient into two separate cash flows like Present worth of
Arithmetic gradient series…. This F/G will be the future value of entire
gradient series.

Final Words about Arithmetic


Gradient
Present Worth(PW) or Annual Worth(AW) of Arithmetic Gradient (P/G
or A/G)
…. Base and Gradient considered separately for both P/G and A/G
…. Get Two series… a PA/AA series and one PG/AG series
….use the factor tables to get values for P A/AA & PG/AG
…… Add both to get PT/AT.

Future worth of Arithmetic Gradient (F/G)


… Base and Gradient are not considered separately
…. No factor values are available so have to relay on formula
….formula directly calculate the future worth of Arithmetic Gradient

1 (1 + ) −1
/ = −
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Geometric Gradient Factors


(Pg /A)
• A Geometric gradient is when the periodic payment is
increasing (decreasing) by a constant percentage:
• the rate at which the cash flow is increasing is “g”
• The initial amount of Geometric Gradient is A1
• Pg is the present worth of entire Gradient Series including A1

• It is important to note that “Initial amount is not considered


separately while working with “Geometric Gradient”
for g ≠ i: for g = i:
1+ =
1− 1+ 1+
=

Note: If g is negative, change signs in front of both g values

Geometric Gradient Factors


(Pg /A)
• A Geometric gradient is when the periodic payment is
increasing (decreasing) by a constant percentage: A (1+g)n-1
1
A1 = $100, g = 10% or 0.1
A2 = $100(1+g)
A (1+g)2
A3 = $100(1+g)2 A1 (1+g) 1
A1

An = $100(1+g)n-1
0 1 2 3 4 ……n
where: A1 = cash flow in period 1 and g = rate of increase
It maybe noted that A1
for g ≠ i: is not considered
separately in geometric
1+ for g = i: gradients
1− 1+
= =
− 1+

Note: If g is negative, change signs in front of both g values


2/15/2016

Future Worth (F/G) and Annuity


(A/G) from Geometric Gradient
Series

• We just learned how to get “Present Value” of a


Geometric Gradient

• We can first derive the Present Worth of the Geometric


Gradient and then can use F/P factor for
calculating future value of a geometric gradient

• Similarly, A/P factor can be applied to P/G factor to


calculate the Annual worth/Annuity series from
Geometric Gradient

Class Practice: 4 Minutes


Determine the present worth of a geometric
gradient series with a cash flow of $50,000 in
year 1 and increases of 6% each year
through year 8. The interest rate is 10% per
year.

for g ≠ i:
1+ for g = i:
1− 1+
= =
− 1+
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Class Practice: 4 Minutes


Determine the present worth of a geometric
gradient series with a cash flow of $50,000 in
year 1 and increases of 6% each year
through year 8. The interest rate is 10% per
year.
   
 1   1  0 .6 
8

 1  1  g 
n
 
 1  0 .743 

Pg  A  1 i    50000  1  0 .10 
 0 .10  0 .06


 50 ,000  
ig   0 .04 
   
   
   

 0 .257 
 50 ,000    50 ,000 ( 6 .425 )
 0 .04 
 $ 321 , 250

Summary of all
Factors!!!
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Single payment Factors


F=?
F/P Factor
F= P(F/P, i%, n)

n and i is given

P is given

P/F Factor
P =? P= F(P/F, i%, n)

n and i is given

F = given

Uniform Series Factors

P/A Factor A/P Factor


P = A(P/A, i%, n) A = P(A/P, i%, n)

F/A Factor A/F Factor


F = A(F/A, i%, n) A = F(A/F, i%, n)
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Athematic Gradient
FG = ?

F = PT(F/P, i%, n)
or
PA = A(P/A, i%, n) 1 (1 + ) −1
/ = −
PG = G(P/G, i%, n)

Athematic Gradient

A = PT(A/P, i%, n)
or
AT = AA + AG
PA = A(P/A, i%, n) AA = A (Annual Worth) &
AG = G(A/G, i, n)
PG = G(P/G, i%, n) 1
= −
(1 + ) −1
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Geometric Gradient
Fg = ?

Pg = ?

for g ≠ i: F = Pg(F/P, i%, n)


1+
1− 1+ Similarly …
=

for g = i:
= A = Pg(A/P, i%, n)
1+

Chapter 3
Combining Factors
and Spreadsheet
Functions

Engineering Economy
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This Chapter Objectives

1. Shifted uniform series


2. Shifted series and single cash flows
3. Shifted gradients

Example

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Year

P=? A = $50
F
P3 = ?

How can we get “Present worth of this series” ?


• Use the P/F factor to find the present worth of each disbursement at year 0 and add
them.
• Use the F/P factor to find the future worth of each disbursement in year 13, add
them, and then find the present worth of the total, using P/F= F( P/F, i ,13).
• Use the F/A factor to find the future amount F/A =A( F/A, i ,10), and then compute
the present worth, using P/F=F(P/F, i ,13).
• Use the P/A factor to compute the “present worth” P3 =A( P/A , i ,10) (which will be
located in year 3, not year 0), and then find the present worth in year 0 by using the
(P/F , i ,3) factor.
2/15/2016

Shifted Uniform Series


• Typically the last method is used for calculating the present worth
of a uniform series that does not begin at the end of period 1.

• Note that a P value is always located 1 year or period prior to the


beginning of the first series amount. Why? Because the P/A factor
was derived with P in time period 0 and A beginning at the end of
period 1.

• The most common mistake made in working problems of this type


is improper placement of P .
Remember:
• When using P/A or A/P factor, PA is always one year ahead of first A
• When using F/A or A/F factor, FA is in same year as last A
• The number of periods n in the P/A or F/A factor is equal to the number of uniform
series values

PA is always one year ahead


of first A

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Year

A = $50
P3 = ?

FA is in same year as last A

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Year

A = $50 F=?
The number of periods n in the P/A or
F/A factor is equal to the number of
uniform series values
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Steps for applying factors to


Shifted Cash Flows

1. Draw a diagram of the positive and negative cash flows.


2. Locate the present worth or future worth of each series on
the cash flow diagram.
3. Determine n for each series by renumbering the cash flow
diagram.
4. Draw another cash flow diagram representing the desired
equivalent cash flow. (Optional)
5. Set up and solve the equations.

Example
The offshore design group at Bechtel just purchased
upgraded CAD software for $5000 now and annual
payments of $500 per year for 6 years starting 3 years
from now for annual upgrades. What is the present
worth in year 0 of the payments if the interest rate is
8% per year?
Solution 1. Draw a diagram of the positive and negative cash flows.
2. Locate the present
worth or future worth of
each series on the cash
i= 8% per year flow diagram.
0 1 2 3 4 5 6 7 8 Year
PA = ? 0 1 2 3 4 5 6 n

P’A = ?
PT = ? A = $500 3. Determine n for each
series by renumbering the
P0 = $5000 cash flow diagram.
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5. Set up P' A = $500( P /A ,8%,6)


and solve
the P = P' ( P /F ,8%, 2)
A A
equations.
P = $500( P /A ,8%,6) ( P /F ,8%, 2)
A

PT = P0 +PA
=5000 + 500( P /A ,8%,6)( P / F ,8%,2)
=5000 +500(4.6229)(0.8573)
$6981.60

Class Practice 5 Minutes Time

Calculate the present worth of the cash flow shown below at i = 10%

i = 10%
0 1 2 3 4 5 6 Actual year

A = $10,000

10% Single Payments Uniform Series Factors

n Compoun Present Sinking Compound Capital Present


d Amount Worth Fund Amount Recovery Worth
(F/P) (P/F) (A/F) (F/A) (A/P) (P/A)
1 1.1000 0.9091 1.00000 1.0000 1.10000 0.9091
5 1.6105 0.6209 0.16380 6.1051 0.26380 3.7908
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Class Practice 5 Minutes Time

Calculate the present worth of the cash flow shown below at i = 10%

i = 10%
0 1 2 3 4 5 6 Actual year
0 1 2 3 4 5 Series year

P’A = ? A = $10,000
PT = ?
Solution
(1) Use P/A factor with n = 5 (for 5 arrows) to get P’A in year 1 ---- A(P/A,10%, 5)

(2) Use P/F factor with n = 1 to move P’A back for PT in year 0 ---- (P/F,10%, 1)

PT = A(P/A,10%, 5) (P/F,10%,1)
= 10,000(3.7908)(0.9091)
$34462

Shifted Series and Random


Single Amounts
• For cash flows that include uniform series and randomly placed
single amounts:
Uniform series procedures are applied to the series amounts

Single amount formulas are applied to the one-time cash flows

• The resulting values are then combined per the problem statement
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Example
Find the present worth in year 0 for the cash flows shown using an interest
rate of 10% per year.
i = 10%
0 1 2 3 4 5 6 7 8 9 10

A = $5000
Solution: $2000

i = 10%
Actual year
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8
Series year
A = $5000
PT = ? $2000

• Find the cash flows both positive and negatives


• Locate the present worth/ future worth
• Determine the “n” by re-numbering the cash flows series
• Uniform series procedures are applied to the series amounts. Single amount
formulas are applied to the one-time cash flows
• The resulting values are then combined per the problem statement

Example:

PT = ? PA = ?

Use P/A to get PA in year 2: PA = 5000(P/A,10%,8) = 5000(5.3349) = $26,675


Move PA back to year 0 using P/F: P0 = 26,675(P/F,10%,2) = 26,675(0.8264) = $22,044
Move $2000 single amount back to year 0: P2000 = 2000(P/F,10%,8) = 2000(0.4665) = $933
Now, add P0 and P2000 to get PT: PT = 22,044 + 933 = $22,977
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Class Practice: 8 Minutes


An engineering company lease the mineral rights to a mining
company on its land. The engineering company makes a
proposal to the mining company that it pay $20,000 per year for
20 years beginning 1 year from now, plus $10,000 six years from
now and $15,000 sixteen years from now. If the mining company
wants to pay off its lease immediately, how much should it pay
now if the investment is to make 16% per year?
16% Single Payments Uniform Series Factors

n Compound Present Worth Capital Present Worth


Amount (F/P) (P/F) Recovery (A/P) (P/A)
6 2.4364 0.4104 0.27139 3.6847
7 2.8262 0.3538 0.24761 4.0386
16 10.7480 0.0930 0.17641 5.6685
17 12.4677 0.0802 0.17395 5.7487
20 19.4608 0.0514 0.16867 5.9228

Solution

0 1 2 3 4 5 6 7 16 17 18 19 20

A =$20,000

P=?
$10,000
$15,000

P = 20,000(P/A ,16%,20)+
10,000( P /F ,16%,6) +
15,000(P/F,16%,16)
P = $20,000(5.9288)+ $ 10,000( 0.4104) + $ 15,000(0.0930)
= $124,075
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Important Points for P and A


of Shifted Gradient Series
• Must use multiple factors to find P in actual year 0, for shifted
gradient series

• The present worth (P) of an arithmetic gradient will always be


located two periods before the gradient starts.

• To find the equivalent A series of a shifted gradient through


all the n periods, first find the present worth of the gradient at
actual time 0, then apply the (A/P, i, n) factor.

• F from gradient series can also be find by first calculating P


and then using F/P factor

Solution
For the cash flows shown, find the future value in year 7 at i = 10% per year

i = 10%
0 1 2 3 4 5 6 7
Actual years
Set up the
0 1 2 3 4 5 6 Gradient years
equations
only… 500
450
550
PG = ? P’G 600
700
650 F=?
G = $-50
Solution: PG is located in gradient year 0 (actual year 1); base amount of $700 is in gradient years 1-6
P’G = A(P/A,10%,6) – G(P/G,10%,6)
P’G = 700(P/A,10%,6) – 50(P/G,10%,6) = 700(4.3553) – 50(9.6842) = $2565
PG= P’G(F/P,10%,1) = 2565(0.9091) = $2331.84

F = P’G(F/P,10%,7) = 2331.84(1.9487) = $4544 Method 1

F = P’G(F/P,10%,6) = 2565(1.7716) = $4544 Method 2


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Using Single Amount factors (Correct


but not Standard methods)

Method 3

Method 4

So for ….
1. Introduction
 What is Economics? Economics for Engineers ?
 What is Engineering Economy ? Performing Engineering Economy
Study ?
 Some Basic Concepts Utility & Various cost concept, Time value of
money (TVM), Interest rate and Rate of Returns, Cash Flow, Economic
Equivalence, Minimum Attractive Rate of Return, Cost of Capital and
MARR, Simple and compound interest rates
2. Various Type of Factors
These were three
Factors Single payment Factors “Foundational
 P/F, F/P Pillars” we need
Uniform Series Factors
 P/A, A/P, F/A, A/F for using “various
Gradient Series Factors engineering
 Arithmetic Gradient and Geometric Gradient economy criteria”
for decision
3. Dealing with Shifted Series making
 Shifted uniform series
 Shifted series and single cash flows
 Shifted gradients
2/15/2016

Lets go for the “Final


foundational pillar” before
studying formal engineering
economy EVAUALTING criteria
of decision making

Chapter 4
Nominal and Effective
Interest Rates

MS291: Engineering Economy

Course Instructor: Dr. Muhammad Sabir


2/15/2016

Content of the Chapter


• Interest Rate: important terminologies
• Nominal and Effective Rate of Interest
• Effective Annual Interest Rate
• Converting Nominal rate into Effective Rate
• Calculating Effective Interest rates
• Equivalence Relations: PP and CP
• Continuous Compounding
• Varying Interest Rates

Lets start with a


Simple Example
2/15/2016

15% per year

Compounded daily

But ..is Due amount


How much Paid $1000 from credit card
after a year is really
you going to $1150 ? Lets do
1000+150 = $1150 ?
pay after 1 check!!!
year ?

Rate is 15% per year but compounding is daily … so the rate at per day is 0.15/365 =
0.000411 per day or 0.0411% per day
Days Amount ($) Interest earned Total due ($) 1161.815863 …..
But this is around
1 1000 Amount x r =0.411 1000.411
16.81% rate … rather
2 1000.411 0.411169 1000. 82269 than 15% stated

3 1000. 82269 0.411169 1001.233507 Lets Continue on


- -------- ------ ------ next slide

365 1161.338553 0.47731 1161.815863

Interest rate is same


for each period
But interest “due” is
1161.815863 …. But this is increasing in every
around 16.81% rate … rather period
than 15% stated

Nominal Interest Rate (15%) Effective Interest Rate (16.81%)


• denoted by (r) • Denoted by (i)
• does not include any consideration of • take accounts of the effect of the
the compounding of compounding period
interest(frequency) • commonly express on an annual
• It is given as: r = interest rate per basis (however any time maybe
period x number of compounding used)
periods
2/15/2016

Previous Learning
• Our learning so for is based “one” interest rate that’s
compounded annually

• Interest rates on loans, mortgages, bonds & stocks are


commonly based upon interest rates compounded more
frequently than annually

• When amount is compounded more than once annually,


distinction need to be made between nominal and
effective rate of interests

Interest Rate:
important terminologies

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) – The time unit over which interest is charged or earned.
For example,10% per year, here CP is a year.

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 the one year interest period.
2/15/2016

Examples of interest rate


Statements

Annual interest rate of 8% compounded monthly …


interest period (t) = 1 year
compounding period (CP) = 1 month
compounding frequency (m) = 12

Annual interest rate of 6% compounded weekly …


interest period (t) = 1 year
compounding period (CP) = 1 Week
compounding frequency (m) = 52

IMPORTANT: Compounding
Period and Interest Rate

• Some times, Compounding period is not mentioned in


Interest statement

• For example, an interest rate of “1.5% per month”


………..It means that interest is compounded each
month; i.e., Compounding Period is 1 month.

• REMEMBER: If the Compounding Period is not


mentioned it is understood to be the same as the time
period mentioned with the interest rate.
2/15/2016

Calculating Effective
Interest Rate

• Effective interest rate per compounding


period can be calculated as follows:

Example:

Three different bank loan rates for electric


generation equipment are listed below.
Determine the effective rate on the basis of the
compounding period for each rate
(a) 9% per year, compounded quarterly
(b) 9% per year, compounded monthly
(c) 4.5% per 6 months, compounded weekly
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Example: Calculating
Effective Interest rates per CP
a. 9% per year, compounded quarterly.
b. 9% per year, compounded monthly.
c. 4.5% per 6 months, compounded weekly.

Class Practice 1:

For nominal interest rate of 18% per year


calculate the effective interest rate
i. If compounding period is yearly 18%
ii. If compounding period is semi-annually 9%

iii. If compounding period is quarterly 4.5%


iv. If compounding period is monthly 1.5%
v. If compounding period is weekly 0.346%
vi. If compounding period is daily 0.0493 %
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Effective Annual Interest


Rates
• When we talk about “Annual” we consider year as the
interest period t , and the compounding period CP can be
any time unit less than 1 year

• Nominal rates are converted into Effective Annual Interest Rates (EAIR)
via the equation:

= (1 + ) −1 = (1 + ) −1

where Effective Interest Rate for any


ia = effective annual interest rate time period
i = effective rate for one compounding period (r/m)
m = number times interest is compounded per year

r = 18% per year,


compounded CP-ly
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Example
For a nominal interest rate of 12% per year, determine the nominal and effective
rates per year for
(a) quarterly, and ia = (1 + i)m – 1
(b) monthly compounding
where ia = effective annual interest rate
i = effective rate for one compounding
Solution: period (r/m)
m = number times interest is compounded
per year
(a) Nominal r per year = 12% per year
Nominal r per quarter = 12/4 = 3.0% per quarter
Effective i per year = (1 + 0.03)4 – 1 = 12.55% per year
(b) Nominal r per month = 12/12 = 1.0% per month
Effective I per year = (1 + 0.01)12 – 1 = 12.68% per year
15% per year
Compounded daily

Effective I per year = (1 + 0.15/365)365 – 1 = 16.81% per year

Economic Equivalence:
From Chapter 1

• Different sums of money at different times may be equal


in economic value at a given rate
$110
Rate of return = 10% per year
Year
0 1
1
$100 now

 $100 now is economically equivalent to $110 one year from


now, if the $100 is invested at a rate of 10% per year
 Economic Equivalence: Combination of interest rate (rate of return) and
time value of money to determine different amounts of money at different
points in time that are economically equivalent …..
Compounding/Discounting (F/P, P/F, F/A, P/G etc.)
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Equivalence Relations: Payment


Period(PP) & Compounding
Period(CP)

• The payment period (PP) is the length of time


between cash flows (inflows or outflows)
• Assume the monthly payments as shown below

E.g., r = nominal 8% per year, compounded semi-annually


CP CP
6 months 6 months

0 1 2 3 4 5 6 7 8 9 10 11 12 Months

│PP │
1 month PP = CP, PP >CP, or PP<CP

Equivalence Relations: Payment


Period(PP) and Compounding Period

• It is common that the lengths of the payment period and the


compounding period (CP) do not coincide

• To do correct calculation of Economic Equivalence


…Interest rate must coincide with compounding period

• It is important to determine if PP = CP, PP >CP, or PP<CP


Length of Time Involves Single Involves Gradient
Amount Series (A, G, or g)
(P and F Only)
PP = CP P/A, P/G, P/g
P/F , F/P
PP > CP F/A etc.
PP < CP P/F, F/P P/A, P/G, F/A etc.
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Thank You