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ENGR 390 Lecture 5: Understanding Money Winter 2007

& Its Management - 2

Chapter 5: Understanding
Money & Its Management
1. If interest period is other than
annual, how do we calculate
economic equivalence?
2. If payments occur more frequently
than annual, how do we calculate
economic equivalence?

Nominal and Effective Interest Rates


with Different Compounding Periods
Effective Rates
Nominal Rate Compounding Compounding Compounding Compounding Compounding
Annually Semi-annually Quarterly Monthly Daily
4% 4.00% 4.04% 4.06% 4.07% 4.08%

5 5.00 5.06 5.09 5.12 5.13

6 6.00 6.09 6.14 6.17 6.18

7 7.00 7.12 7.19 7.23 7.25

8 8.00 8.16 8.24 8.30 8.33

9 9.00 9.20 9.31 9.38 9.42

10 10.00 10.25 10.38 10.47 10.52

11 11.00 11.30 11.46 11.57 11.62

12 12.00 12.36 12.55 12.68 12.74

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Effective Annual Interest Rates


(9% compounded quarterly)

First quarter Base amount $10,000


+ Interest (2.25%) + $225

Second quarter = New base amount = $10,225


+ Interest (2.25%) +$230.06

Third quarter = New base amount = $10,455.06


+ Interest (2.25%) +$235.24

Fourth quarter = New base amount = $10,690.30


+ Interest (2.25 %) + $240.53
= Value after one year = $10,930.83

Effective Annual Interest Rate

ia = (1 + r / M ) − 1 M

r = nominal interest rate per year


ia = effective annual interest rate
M = number of interest periods per year

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Equivalence Analysis using Effective


Interest Rate

† Identify the compounding period (e.g.,


annually, quarterly, monthly
† Identify the payment period (e.g., annual,
quarter, month, week, etc), etc)
† Find the effective interest rate that
covers the payment period.

When Payment Periods and


Compounding Periods Coincide
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)
Step 4: Use the appropriate interest formula
using i and N above

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Effective Interest Rate per Payment Period (i)

i = [1 + r / CK ]C − 1
C = number of interest periods per
payment period
K = number of payment periods per year
r/K = nominal interest rate per
payment period

What happens when payment period is not annual?

Case 1: 8% compounded quarterly


Payment Period = Quarter
Interest Period = Quarterly
1st Q

2nd Q 3rd Q 4th Q


1 interest period Given r = 8%,
K = 4 payments per year
C = 1 interest periods per quarter
M = 4 interest periods per year

i = [1 + r / C K ] C − 1
= [1 + 0 . 0 8 / (1 ) ( 4 ) ] 1 − 1
= 2 . 0 0 0 % p e r q u a r te r

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Case 2: 8% compounded monthly


Payment Period = Quarter
Interest Period = Monthly
1st Q

2nd Q 3rd Q 4th Q


3 interest periods Given r = 8%,
K = 4 payments per year
C = 3 interest periods per quarter
M = 12 interest periods per year

i = [1 + r / C K ] C − 1
= [1 + 0 . 0 8 / ( 3 ) ( 4 ) ] 3 − 1
= 2 . 0 1 3 % p e r q u a r te r

Case 3: 8% compounded weekly


Payment Period = Quarter
Interest Period = Weekly
1st Q

2nd Q 3rd Q 4th Q


13 interest periods Given r = 8%,
K = 4 payments per year
C = 13 interest periods per quarter
M = 52 interest periods per year

i = [1 + r / C K ] C − 1
= [1 + 0 . 0 8 / (1 3 )( 4 )]1 3 − 1
= 2 . 0 1 8 6 % p e r q u a rte r

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Payment Periods Differ from


Compounding Periods
Step 1: Identify the following parameters
M = No. of compounding periods per year
K = No. of payment periods per year
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 ] C − 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

Discrete Case: Quarterly Deposits with


Monthly Compounding
F3 = ?
Year 1 Year 2 Year 3

r = 12%, 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
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

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Problem 4
You will deposit $1000 every 3 months for
4 years into an account that pays interest
of 8% per year, compounded monthly. The
first deposit will be in 3 months. How
much will be in the account in 4 years?
GIVEN:
A = $1,000 r = 8%/yr i = [1 + 0 .08 /( 3)( 4 )] 3 − 1
C = 3 periods/qr K = 4 payments/yr
M = 12 mo/yr = 2 .0130 %
FIND F:
DIAGRAM: F?
N = 4(4) = 16
0 1 2 3 4 yrs
F = $1,000 (F/A, 2.013%, 16)
= $18,658.12
$1,000

Continuous Compounding

i = [1 + r / CK ]C − 1
where CK = number of compounding periods
per year

continuous compounding => C → ∞


i = lim[( 1 + r / CK ) C − 1]
= er /K −1

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Case 4: 8% compounded continuously


Payment Period = Quarter
Interest Period = Continuously
1st Q

2nd Q 3rd Q 4th Q


∞ interest periods
Given r = 8%,
K = 4 payments per year

i = er / K −1
= e 0 .02 − 1
= 2 .0201 % per quarter

Summary: Effective interest rate per quarter

Case 1 Case 2 Case 3 Case 4

8% compounded 8% compounded 8% compounded 8% compounded


quarterly monthly weekly continuously

Payments occur Payments occur Payments occur Payments occur


quarterly quarterly quarterly quarterly

2.000% per 2.013% per 2.0186% per 2.0201% per


quarter quarter quarter quarter

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Payment Periods Differ from


Compounding Periods
Step 1: Identify the following parameters
M = No. of compounding periods per year
K = No. of payment periods per year
C = No. of interest periods per payment period
Step 2: Compute the effective interest rate per payment period
•For discrete compounding C
i = [1 + r / CK ] − 1
•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

Continuous Case: Quarterly Deposits


with Continuous Compounding

Year 1 Year 2 Year 3


F3 = ?
r = 12%, 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: i
i = e0.12/ 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

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Problem 5
Determine the total amount
accumulated in an account paying
interest at the rate of 10% per year,
compounded continuously if
deposits of $1,000 are made at the
end of each of the next 5 years.
DIAGRAM: F? GIVEN:
A = $1,000 r = 10%/yr
C = ∞ K = 1 payment/yr
0 1 2 3 5 yrs N = 5 yrs
FIND F:
$1,000

Problem 5
GIVEN:
A = $1,000 r = 10%/yr
C = ∞ K = 1 payment/yr
N = 5 yrs
FIND F:
i = e0.10/1 −1
DIAGRAM: F? = 10.517 % per year
0 1 2 3 5 yrs
N=5
F = $1,000 (F/A, 10.517%, 5)
$1,000 = $6,168.25

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Problem 6
A firm pays back a $10,000 loan with
quarterly payments over the next 5
years. The $10,000 returns 4% APR
compounded monthly. What is the
quarterly payment amount ?
DIAGRAM:
GIVEN:
$10,000 P = $10,000 r = 4%/yr
C = 3 interest periods/quarter
K = 4 payments/yr
1 2 3 5 yrs = 20 qtr
M = 12 compounding periods/yr
0
FIND A:
$A = ?

Problem 6
GIVEN:
P = $10,000 r = 4%/yr
C = 3 interest periods/quarter
K = 4 payment periods/yr
M = 12 compounding periods/yr
DIAGRAM: FIND A:
$10,000 i = [1 + 0 .04 /( 3)( 4 )] 3 − 1
= 1 .0033 %
1 2 3 5 yrs = 20 qtr
0
$A = ? N = 4(5) = 20
A = $10,000 (A/P, 1.0033%, 20)
= $554.30

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Complex Cash Flows


Complex Cash Flows – Separate
complex cash flows into
component cash flows in order to
use the standard formulas.
Remember: You can only combine
cash flows if they occur at the same
point in time.

Problem 1
A construction firm is considering the purchase of an
air compressor.

The compressor has the following expected end of


year maintenance costs:
Year 1 $800
Year 2 $800
Year 3 $900
Year 4 $1000
Year 5 $1100
Year 6 $1200
Year 7 $1300
Year 8 $1400

What is the present equivalent maintenance cost if the


interest rate is 12% per year compounded annually?

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ENGR 390 Lecture 5: Understanding Money Winter 2007
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Problem 1 – Alt Soln 1


GIVEN:
MAINT COST1-8 PER YEAR TABLE
i = 12%/YR, CPD ANNUALLY
FIND P: P = PA + PG + PF = A(P|A,i,N) + G(P|G,i,N) + F(P|F,i,N)
= $700(P|A,12%,8) + $100(P|G,12%,8) + $100(P|F,12%,1)
DIAGRAM: = $700(4.9676) + $100(14.4715) + $100(0.8929) = $5,014
P?
PA ?
1 2 3 4
N=8 1 2 3 4
N=8
0 $700 PF ?
0
N=1
$700
$100 $100 $200 PG ? 0
$300 $700 $100
1 2 3 4
N=8
0
NOTE: CAN SEPARATE INTO 3 CASH FLOWS: $100 $200
ANNUAL, LINEAR GRADIENT, AND FUTURE $300 $700

GIVEN:
Problem 1 – Alt Soln 2
MAINT COST1-8 PER DIAGRAM
i = 12%/YR, CPD ANNUALLY
FIND P: P = PA + PG(PPG) = A(P|A,i,N) + G(P|G,i,N-1)(P|F,i,1)
= $800(P|A,12%,8) + $100(P|G,12%,7)(P|F,12%,1)
DIAGRAM: = $800(4.9676) + $100(11.6443)(0.8929) = $5,014
P? PA ?
1 2 3 4 1 2 3 4
N=8 N=8
0 0
$800 $800
$100 $200 PPG ? PG ?
0 1 2 3
$600 N=7
0 1
NOTE: PG MUST BE OFFSET ONE YEAR – SO PG ? $100 $200
BRING THE OFFSET YEAR BACK TO TIME ZERO $600

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ENGR 390 Lecture 5: Understanding Money Winter 2007
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Problem 2
A young couple has decided to make advance plans for
financing their 3 year old daughter’s college education.
Money can be deposited at 8% per year, compounded
annually.
What annual deposit on each birthday, from the 4th to the
17th (inclusive), must be made to provide $7,000 on each
birthday from the 18th to the 21st (inclusive)?
DIAGRAM: GIVEN:
$7,000
WITHDRAWALS18-21 = $7 000
4 17 i = r = 8%/YR, CPD YEARLY
FIND A4-17:
0 18 21 yrs
P17 = A(P|A,i,N) = A(F|A,i,N)
A?
= 7 000(P|A,8%,4) = A(F|A,8%,14)
STRATEGY: CAN BREAK INTO 2 CASH FLOWS,
SO PICK A CONVENIENT POINT IN TIME AND SET = 7 000(3.3121) = A(24.2149)
DEPOSITS EQUAL TO WITHDRAWALS…
A = $957

Problem 3
Anita Plass-Tuwurk, who owns an engineering consulting
firm, bought an old house to use as her business office. She
found that the ceiling was poorly insulated and that the heat
loss could be cut significantly if 6 inches of foam insulation
were installed. She estimated that with the insulation she
could cut the heating bill by $40 per month and the air
conditioning cost by $25 per month. Assuming that the
summer season is 3 months (June, July, August) of the year
and the winter season is another 3 months (December,
January, and February) of the year, how much can she
spend on insulation if she expects to keep the property for 5
years? Assume that neither heating nor air conditioning
would be required during the fall and spring seasons. She is
making this decision in April about whether to install the
insulation in May. If the insulation is installed, it will be paid
for at the end of May. Anita’s interest rate is 9%,
compounded monthly.

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ENGR 390 Lecture 5: Understanding Money Winter 2007
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GIVEN:
Problem 3
SAVINGS = $40/MO(DEC,JAN, FEB); $25/MO (JUN, JUL, AUG)
r = 9%/YR, CPD MONTHLY
FIND P(SAVINGS OVER 5 YEARS):
1ST YR DIAGRAM: 5 YR DIAGRAM:
$40 PA
$25
0
0
1 2 3 4 5 6 7 8 9 10 11 12 MO 1 2 3 4 5 YRS
PA ? α β P?

i = r = 0.09 = 0.75% / MO
M 12

PA = Pα + Pβ(PPβ) = Aα(P|A,i,Nα) + Aβ(P|A,i,Nβ)(P|F,i,6)


= $25(P|A,0.75%,3) + $40(P|A,0.75%,3)(P|F,0.75%,6)
= $25(2.9556) + $40(2.9556)(0.9562) = $186.94

GIVEN:
Problem 3
SAVINGS = $40/MO(DEC,JAN, FEB); $25/MO (JUN, JUL, AUG)
r = 9%/YR, CPD MONTHLY
FIND P(SAVINGS OVER 5 YEARS):
5 YR DIAGRAM: $186.94 $186.94
$186.94 +
= 0 0
1 2 3 4 5 YRS 1 2 3 4 5 YRS
0
1 2 3 4 5 YRS P0 ? PA ?
P? P = P0 + PA = A + A(P | A, i,N)
C = 12 K =1
C ⎡ (1 + i)N − 1⎤
⎛ r ⎞ = A + A⎢ N ⎥
i = ⎜1 + ⎟ −1
⎝ CK ⎠ ⎣ i(1 + i) ⎦
12 = $186.94 + $186.94(P | A,9.38%,4)
⎛ 0.09 ⎞
= ⎜1 + ⎟ −1 ⎡ (1 + 0.0938 )4 − 1 ⎤
⎝ 12(1) ⎠ = $186.94 + $186.94 ⎢ 4⎥
= 9.38% ⎣ 0.0938(1 + 0.0938 ) ⎦
= $186.94 + $186.94[3.21288 ] = $787.56

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Credit Card Debt

† Annual fees
† Annual
percentage rate
† Grace period
† Minimum
payment
† Finance charge

Methods of Calculating Interest on Credit Card


Method Description Interest You Owe

Adjusted The bank subtracts the amount of Your beginning balance is $3,000.
Balance your payment from the beginning With the $1,000 payment, your
balance and charges you interest on new balance will be $2,000. You
the remainder. This method costs pay 1.5% on this new balance,
you the least. which will be $30.
Average The bank charges you interest on the Your beginning balance is $3,000.
Daily average of the amount you owe each With your $1,000 payment at the
Balance day during the period. So the larger 15th day, your balance will be
the payment you make, the lower the reduced to $2,000. Therefore,
interest you pay. your average balance will be
(1.5%)($3,000+$2,000)/2=$37.50.
Previous The bank does not subtract any Regardless of your payment size,
Balance payments you make from your the bank will charge 1.5% on your
previous balance. You pay interest beginning balance $3,000:
on the total amount you owe at the (1.5%)($3,000)=$45.
beginning of the period. This method
costs you the most.

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Buying versus Lease Decision

Option 1 Option 2
Debt Financing Lease Financing
Price $14,695 $14,695
Down payment $2,000 0
APR (%) 3.6%
Monthly payment $372.55 $236.45
Length 36 months 36 months
Fees $495
Cash due at lease end $300
Purchase option at lease end $8.673.10
Cash due at signing $2,000 $731.45

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ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2

Which Option is Better?

† Debt Financing:
Pdebt = $2,000 + $372.55(P/A, 0.5%, 36)
- $8,673.10(P/F, 0.5%, 36)
= $6,998.47

† Lease Financing:
Please = $495 + $236.45 + $236.45(P/A, 0.5%, 35)
+ $300(P/F, 0.5%, 36)
= $8,556.90

Summary

† Financial institutions often quote interest


rate based on an APR.
† In all financial analysis, we need to
convert the APR into an appropriate
effective interest rate based on a
payment period.
† When payment period and interest
period differ, calculate an effective
interest rate that covers the payment
period.

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