CE533 Chp3 Nominal Rate

CE 533 - ECONOMIC DECISION
ANALYSIS IN CONSTRUCTION
Chapter III- Nominal and Effective
Interest Rates
By
Assoc. Prof. Dr. Ahmet ZTA
GAZANTEP University
Department of Civil Engineering
CHP 3- Nominal and Effective Interest

Rates
Contents
Nominal and Effective interest rate

staements
Effective interest rate formulation
Compounding and Payment Periods
Equivalence Calculations
- Single Amounts
- Series: PP >= CP
- Series: PP < CP
Using spreatsheets
CE 533 Economic Decision Analysis 2 / 54
3.1 Nominal & Effective Interest Rates

In this chapter, we discuss nominal and effective
interest rates, which have the same basic
relationship.
The difference here is that the concepts of nominal
and effective are used when interest is compounded
more than once each year.
For example, if an interest rate is expressed as 1%
per month, the terms nominal and effective interest
rates must be considered.
Every nominal interest rate must be converted into
an effective rate before it can be used in formulas,
factor tables, or spreadsheet functions because they
are all derived using effective rates.

Before discussing the conversion from nominal
to effective rates, it is important to identify a
stated rate as either nominal or effective.
There are 3 general ways of expressing interest
rates (See Table 3.1).
Example:
Interest is 12% per year
Interest is 8% per year, compounded monthly
Effctive Interest is 10% per year,

compounded monthly
These 3 statements in the top third of the table show that

an interest rate can be stated over some designated time
period without specifying the compounding period.
Such interest rates are assumed to be effective rates with
the compounding period (CP) same as that of the stated
interest rate.
The above interest statementsd prevail three conditions:

(1) Compounding period is identified, (2) This compounding
period
is shorter than the time period over which the interest is
stated,
and (3) The interest rate is designated neither as nominal
nor as
In above statements in Table 3.1, the word effective

precedes or follows the specified, and the
compounding period is also given. These interest
rates are obviously effective rates over the
respective time periods
stated. Decision Analysis 7 / 54
CE 533 Economic
3.1 Two Common Forms of Quotation

Two types of interest quotation
1. Quotation using a Nominal Interest Rate
2. Quoting an Effective Periodic Interest Rate
Nominal and Effective Interest rates

are common in business, finance,
and engineering economy
Each type must be understood in
order to solve various problems
where interest is stated in various
ways.
3.2 Effective Interest Rate

Formulation
Understanding effective Interest rates requires a definition of a

nominal interest rate r as the interest rate per period times the
number of periods.
A Nominal Interest Rate, r.

Definition:
A Nominal Interest Rate, r,
is an interest Rate that does
not include
any consideration
of compounding

Formulation
The term nominal
Nominal means, in name only,

not the real rate in
this case.
CE 533 Economic Decision Analysis
10 /

Formulation
Mathematically we have the
following definition:
r=
(interest rate per period)(No. of Periods)
Examples:
1) 1.5% per month for 24 months
Same as: (1.5%)(24) = 36% per 24 months
2) 1.5% per month for 12 months
Same as (1.5%)(12 months) = 18%/year
(3.1)
11 /

Formulation
Equation for converting a nominal Interest
rate into an effective Interest rate is:
i per period = (1 + r/m)m 1
(2)
r = interest rate per period x number of periods,

m = number of times interest is comounded
= effective interst rate
12 /
3.2 Example 1:
Given:
interest is 8% per year compounded
quarterly.
What is the true annual interest rate?
Calculate:
i = (1 + 0.08/4)4 1
i = (1.02)4 1 = 0.0824 = 8.24%/year
13 /
3.2 Example 2:
Given: 18%/year, comp. monthly
What is the true, effective annual
interest rate?
r = 0.18/12 = 0.015 = 1.5% per month.
1.5% per month is an effective monthly
rate.
The effective annual rate is:
(1 + 0.18/12)12 1 = 0.1956 = 19.56%/year
14 /

Formulation
if we allow compounding to occur more and more

frequently, the compounding period becomes shorter
and shorter. Then m, the number of compounding
periods increases. This situation occurs in businesses
that have a very large number of CF every day.
i = er 1
Where r is the nominal rate of interest
compounded continuously.
This is the max. interest rate for any value of
r compounded continuously.
15 /

Formulation
Example:
What is the true, effective annual interest
rate if the nominal rate is given as:
r = 18%, compounded continuously
Or, r = 18% c.c.
Solve e0.18 1 = 1.1972 1 = 19.72%/year

The 19.72% represents the MAXIMUM i for 18%
compounded anyway you choose!
16 /

Formulation
To find the equivalent nominal rate
given the i when interest is
compounded continuously, apply:
r ln(1 i )
17 /

Formulation
Example
Given r = 18% per year, cc, find:
A. the effective monthly rate
B. the effective annual rate
a. r/month = 0.18/12 = 1.5%/month

Effective monthly rate is e0.015 1 = 1.511%
b. The effective annual interest rate is e0.18 1 = 19.72%
per year.
18 /

Formulation
Example
An investor requires an effective return of
at least 15% per year.
What is the minimum annual nominal rate
that is acceptable if interest on his
investment is compounded continuously?
To start: er 1 = 0.15
Solve for r
19 /

Formulation
Example - Solution
er 1 = 0.15
er = 1.15
ln(er) = ln(1.15)
r = ln(1.15) = 0.1398 = 13.98%
A rate of 13.98% per year, cc. generates the same
as 15% true effective annual rate.
20 /
3.3 Reconciling Compounding periods

& Payment Periods (PP)
The concepts of nominal and effective Interest
rates are introduced, considering the
compounding period.
Now, lets consider the frequency of the payments
of receipts within the cash-flow time interval.
For simplicity, the frequency of the payments or
receipts is known as the payment period (PP).
It is important to distinguish between the
compounding period (CP) and the payment period
because in many instances the two do not
coincide.
21 /

For example, if a company deposited money
each month into an account that pays a
nominal interest rate of 6% per year
compounded semiannually, the payment
period would be 1 month while the CP would
be 6 months as shown in below Figure.
22 /

So, to solve problems first step is to determine
the relationship between the compounding
period and the payment period.
The next three sections deseribe procedures for
determining the correct i and n values for use in
formulas, factor tables, and spreadsheet
functions.
In general, there are three steps:
1. Compare the lengths of pp and CP.
2. Identify the CF series as involving only single
amounts (P and F) or series amounts (A, G, or g).
3. Select the proper i and n values.
23 /
3.4 Equivalence Calculations of Single

Amount Factors
There are many correct combinations of i and n that can be used
when only single amount
factors (F/P and P/F) are involved. This is because there are only
two requirements:
(1) An effective rate must be used for i, and
(2) Time unit on n must be the same as that on i.
In standard factor notation, the single-payment equations can be
generalized.
P= F(P/F, effective i per period, number of periods)
F= P(F/P, effective i per period, number of periods)
Thus, for a nominal interest rate of 12% per year compounded
monthly, any of
the i and corresponding n values shown in Table 3.4 could be
used (as well as
many others not shown) in the factorso For example, if an
effective quarterly
24 /

Amount Factors
Thus, for a nominal interest rate of 12% per year
compounded monthly, any of the i and
corresponding n values shown in Table 3.4 could be
used in the factors.
Example: if an effective quarterly interest rate is
used for i, that is, (1.01)3 - 1 = 3.03%, then the n
time unit is 4 quarters.
Alternatively, it is always
correct to determine the effective i
per payment period using
Equation [3.2] and to use
standard factor equations to
calculate P, F, or A.
25 /

Amount Factors
Example: Sherry expects to deposit $1000 now,
$3000 4 years from now, and $1500 6 years from
now and eaen at a rate of 12% per year
compounded semiannually through a companysponsored savings plan.
What amount can she withdraw 10 years from now?
Solution:
Only single-amount P and F values are involved (See
Figure below).
26 /

Amount Factors
Since only effective rates can be present in the
factors, use an effective rate of 6% per semiannual
compounding period and semiannual payment
periods.
The future worth is calculated as;
27 /
3.4 Single Amounts: PP >= CP

Example:
r = 15%, c.m.
(compounded monthly)
Let P = $1500.00
Find F at t = 2 years.
15% c.m. = 0.15/12 = 0.0125 =
1.25%/month.
n = 2 years OR 24 months
Work in months or in years
28 /

Approach 1. (n relates to months)
State:
F24 = $1,500(F/P,0.15/12,24);
i/month = 0.15/12 = 0.0125 (1.25%);
F24 = $1,500(F/P,1.25%,24);
F24 = $1,500(1.0125)24 =
$1,500(1.3474);
F24 = $2,021.03.
29 /

Approach 2. (n relates to years)
State:
F24 = $1,500(F/P,i%,2);
Assume n = 2 (years) we need to apply an

annual effective interest rate.
i/month =0.0125
Effective I = (1.0125)12 1 = 0.1608 (16.08%)
F2 = $1,500(F/P,16.08%,2)
F2 = $1,500(1.1608)2 = $2,021.19
Slight roundoff compared to approach 1
30 /
3.4 Example 2.
F 10 = ?
Consider
r = 12%/yr, c.s.a.
0
$1,000
10
$1,500
$3,000
Suggest you work this in 6- month time frames

Count n in terms of 6-month intervals
31 /
3.4 Example 2.
F 10 = ?
Renumber the time line

r = 12%/yr, c.s.a.
0
$1,000
10
12
14
16
18
20
$1,500
$3,000
i/6 months = 0.12/2 = 6%/6 months; n counts 6month time periods

32 /
3.4 Example 2.
F 20 = ?
Compound Forward
r = 12%/yr, c.s.a.
0
$1,000
10
12
14
16
18
20
$1,500
$3,000
F20 = $1,000(F/P,6%,20) + $3,000(F/P,6%,12) +

$1,500(F/P,6%,8) = $11,634
33 /
3.4 Example 2. Let n count years.

F 10 = ?
Compound Forward
r = 12%/yr, c.s.a.
0
$1,000
10
$1,500
$3,000
IF n counts years, interest must be an annual rate.

Eff. A = (1.06)2 - 1 = 12.36%
Compute the FV where n is years and i = 12.36%!
CE 533 Economic Decision Analysis 34 /
3.5 Equivalence Calculations

Involving Series With PP >= CP
When CF of the problem dictates the use of one or more
of the uniform series or gradient factors, the
relationship between CP and PP must be determined.
The relationship will be one of the following three cases:
Type 1. Payment period equals compounding period,
PP = CP
Type 2. Payment period is longer than compounding
period, PP > CP.
Type 3. Payment period is shorter than compounding
period, PP < CP.
The procedure for the first two CF types is the same.
Type 3 problems are discussed in the following section.
35 /

Involving Series With PP >= CP
When PP = CP or PP > CP, the following procedure
always applies:
Step 1. Count the number of payments and use
that number as n.
For example, if payments are made quarterly for 5
years, n is 20.
Step 2. Find the effective interest rate over the
same time period as n in step 1.
For example, if n is expressed in quarters, then the
effective interest rate per quarter must be used.
36 /
3.5 Series Example
F7 = ??
Consider:
0
A = $500 every 6 months
Find F7 if r = 20%/yr, c.q. (PP > CP)

We need i per 6-months effective.
i6-months = adjusting the nominal rate to fit.
37 /
3.5 Series Example

Adjusting the interest
r = 20%, c.q.
i/qtr. = 0.20/4 = 0.05 = 5%/qtr.
2-qtrs in a 6-month period.
i6-months = (1.05)2 1 = 10.25%/6-months.
Now, the interest matches the payments.
Fyear 7 = Fperiod 14 = $500(F/A,10.25%,14)
F = $500(28.4891) = $14,244.50
38 /
3.5 This Example: Observations

Interest rate must match the frequency of
the payments.
In this example we need effective interest
per 6-months: Payments are every 6months.
The effective 6-month rate computed to
equal 10.25% - un-tabulated rate.
Calculate the F/A factor or interpolate.
Or, use a spreadsheet that can quickly
determine the correct factor!
39 /
3.5 This Example: Observations

Do not attempt to adjust the payments to
fit the interest rate!
This is Wrong!
At best a gross approximation do not do
it!
This type of problem almost always
results in an un-tabulated interest rate
You have to use your calculator to

compute the factor or a spreadsheet
model to achieve exact result.
40 /

Involving Series With PP < CP
This situation is different than the last.
Here, PP is less than the compounding
period (CP).
Raises questions?
Issue of interperiod compounding
An example follows.
41 /

Consider a one-year cash flow situation.
Payments are made at end of a given month.
Interest rate is r = 12%/yr, c.q.
$120
$90
$150
$75
$100
$45
10
11
12
$50
$200
42 /

r =12%/yr. c.q.
$120
$90
CP-1
0
CP-2
2
$150
$45
CP-3
$75
$100
CP-4
9
10
11
12
$50
$200
Note where some of the cash flow amounts fall with

respect to the compounding periods!
43 /

Will any interest be earned/owed on the $200 since
interest is compounded at the end of $120
each quarter?
$90
CP-1
0
$150
$200
$45
The $200 is at the end of

4
5
6
7
8
9
10
11
month
2 and
will
it earn
$50to go
for one month
$75interest
$100
to the end of the first
compounding period?
12
The last month of the first compounding period.

Is this an interest-earning period?
44 /

The $200 occurs 1 month before the
end of compounding period 1.
Will interest be earned or charged on
that $200 for the one month?
If not then the revised cash flow
diagram for all of the cash flows should
look like..
45 /

$165
Revised CF Diagram
$90
5
$75
$150
$200 $200
6
$100
$90
$45
10
11
12
$50
$50
$175
All negative CFs move to the end of their respective

quarters and all positive CFs move to the beginning
of their respective quarters.
46 /

$165
Revised CF Diagram
$90
10
11
12
$50
$150
$200
$175
Now, determine the future worth of this revised series

using the F/P factor on each cash flow.
47 /

With the revised CF compute the future
worth.
r = 12%/year, compounded quarterly
i = 0.12/4 = 0.03 = 3% per quarter
F12 = [-150(F/P,3%,4) 200(F/P,3%,3) + (-175 +90)

(F/P,3%,2) + 165(F/P,3%,1) 50]
= $-357.59
48 /
3.7 Using Excel for i Computations

In Excel, two functions are used to convert
between nominal and effective interest rates:
the EFFECT or NOMINAL functions.
Find effective rate:
EFFECT(nominal-rate, compounding frequency)
The nominal rate is r and must be expressed
over the same time period as that of the
effective rate requested.
The compounding frequency is m, which must
equal the number of times interest is
compounded for the period of time used in the
effective rate.
49 /
3.7 Using Excel for i Computations
Therefore, in the second example of Figure 3.6

where effective quarterly rate is requested, enter
the nominal rate per quarter (3.75%) to get an
effective rate per quarter, and enter m = 3, since
monthly compounding occurs 3 times in a quarter.
50 /
3.7 Using Excel for i calculations

Find nominal:
NOMINAL(effective rate, compounding frequency
per year)
This function always displays the annual nominal
rate. Accordingly, the m entered must equal the
number of times interest is compounded annually.
if the nominal rate is needed for other than
annually, use Equation [3.1] below to calculate it.
r = (interest rate per period)(No. of

Periods)
This is why the result of the NOMINAL function in
Example 4 of Figure 3.6 is divided by 2.
51 /
3.7 Using Excel for i calculations
Study Example 3.7:

Use EXCEL to find the
semiannual cash flow requested in
Example 3.5.
52 /
Chapter Summary
Many applications use and apply nominal
and effective compounding
Given a nominal rate must get the interest
rate to match the frequency of the
payments.
Apply the effective interest rate per payment
period.
When comparing varying interest rates, must
calculate the Effective i in order to
compare.
53 /
Chapter III
End of the Chapter III

CE533 Chp3 Nominal Rate

Hochgeladen von

Dokumentinformationen

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

CE533 Chp3 Nominal Rate

Hochgeladen von

Copyright:

Verfügbare Formate

CE 533 - ECONOMIC DECISION

CHP 3- Nominal and Effective Interest

Nominal and Effective interest rate

3.1 Nominal & Effective Interest Rates

3.1 Nominal & Effective Interest Rates

Interest is 12% per year

Interest is 8% per year, compounded monthly

Effctive Interest is 10% per year,

3.1 Nominal & Effective Interest Rates

These 3 statements in the top third of the table show that

3.1 Nominal & Effective Interest Rates

The above interest statementsd prevail three conditions:

3.1 Nominal & Effective Interest Rates

In above statements in Table 3.1, the word effective

3.1 Two Common Forms of Quotation

1. Quotation using a Nominal Interest Rate

2. Quoting an Effective Periodic Interest Rate

Nominal and Effective Interest rates

3.2 Effective Interest Rate

Understanding effective Interest rates requires a definition of a

A Nominal Interest Rate, r.

CE 533 Economic Decision Analysis 9 / 54

3.2 Effective Interest Rate

The term nominal

Nominal means, in name only,

CE 533 Economic Decision Analysis

3.2 Effective Interest Rate

3.2 Effective Interest Rate

i per period = (1 + r/m)m 1

r = interest rate per period x number of periods,

3.2 Effective Interest Rate

if we allow compounding to occur more and more

3.2 Effective Interest Rate

r = 18%, compounded continuously

Or, r = 18% c.c.

Solve e0.18 1 = 1.1972 1 = 19.72%/year

CE 533 Economic Decision Analysis

3.2 Effective Interest Rate

3.2 Effective Interest Rate

A. the effective monthly rate

B. the effective annual rate

a. r/month = 0.18/12 = 1.5%/month

3.2 Effective Interest Rate

3.2 Effective Interest Rate

3.3 Reconciling Compounding periods

3.3 Reconciling Compounding periods

CE 533 Economic Decision Analysis

3.3 Reconciling Compounding periods

3.4 Equivalence Calculations of Single

CE 533 Economic Decision Analysis

3.4 Equivalence Calculations of Single

CE 533 Economic Decision Analysis

3.4 Equivalence Calculations of Single

CE 533 Economic Decision Analysis

3.4 Equivalence Calculations of Single

CE 533 Economic Decision Analysis

3.4 Single Amounts: PP >= CP

CE 533 Economic Decision Analysis

3.4 Single Amounts: PP >= CP

i/month = 0.15/12 = 0.0125 (1.25%);

CE 533 Economic Decision Analysis

3.4 Single Amounts: PP >= CP

Assume n = 2 (years) we need to apply an

Effective I = (1.0125)12 1 = 0.1608 (16.08%)