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 4.
C 1
Simple Interest
O
4.
N 2
Compound Interest
TE
N 4.
3
INTEREST RATE
Nominal and Effective Interest Rates
AND
T
S 4.
4
EQUIVALENCE
The Concept Equivalence

4.
Dr Nordiana Azlin binti Othman
5 Cash Flow-Diagram Table

With Wisdom We ndiana@edu.utm.my

 Aims - TLOs

Able to perform calculations for

interest rates and cash flows that
occur on a time basis other than yearly

1 Interest Rate and Equivalence

 4.
1
Simple Interest

2 Interest Rate and Equivalence


Interest
The cost of using someone elses
money
It that sense, it may be thought of
as rent. The money you borrow
from the bank belongs to savers
whom the bank pays interest. In
turn, the bank charges you interest.
What you pay to the bank as
interest is more than what the bank
pays to the saver. The bank is thus
the middle man pocketing the
difference in interest.
3 Interest Rate and Equivalence
Introduction
Interest
A measure of Rate
interest for a given
loan during the loan period
Denoted as i and expressed in
percentage (%) per year
Annual interest rate of 8% sated as i =
8%
Let say that you borrow a sum of $350
for one year. This sum called as
principal.
*S. K Vajpayee in Fundamentals of Economics for
Engineering Technologists and Engineers, page 7
 Simple Interest

Defn
ition
Interest earned on only the principal amount
during each interest period*.

Calculated on Easy (simple)

the principal
to calculate
amount only

*Chan S. Park in Fundamentals of Engineering

Economics, page 44
4 Interest Rate and Equivalence
 Simple Interest

Example
HP borrowed money to do rapid prototyping for a new
ruggedized computer targets desert oilfeld conditions. The
loan is $10, 000 for 3 years at 5% per year simple interest.
How much money will HP repay at the end of 3 years?

End of Amount Interest Amount Amount

year borrowed Owed Paid
0 $10, 000 - - -
1 - $ 500 $ 10, 500 $0
2 - $ 500 $ 11, 000 $0
3 - $ 500 $ 11, 500 $ 11, 500

5 Interest Rate and Equivalence

 4.
Compound Interest
2

6 Interest Rate and Equivalence

 Compound Interest
Defn
ition
The interest earned in each period is calculated based
on the total amount at the end of the previous period*.

Interest that not only applies to the initial amount but also to the
interest that has accumulated so far
Calculating compound interest is slightly more involved
Compound interest is the most widely used form of interest today

*Chan S. Park in Fundamentals of Engineering

Economics, page 45
7 Interest Rate and Equivalence
 Compound Interest

Example
If HP borrows $ 1,000 from a different source at 5% per year
compound interest, compute the total amount due after 3
years. Compare the results of this and the previous example.

End of Amount Interest Amount Amount

year borrowed Owed Paid
0 $1000

1 - $ 50.00 $ 1050.00 $0
2 - $ 52.50 $ 1102.50 $0
3 - $ 55.13 $ 1157.63 $ 1157.63

8 Interest Rate and Equivalence

 Simple vs. Compound Interest

Example
Suppose you deposit RM 15, 000 in a bank savings account
that pays interest at a rate of 8% per year. Assume that you
dont withdraw the interest earned at the end of each period
(year), but instead let it accumulate.
a) How much would you have at the end of year 5 with
simple interest?
b) How much would you have at the end of year 5 with
compound interest?
Simple Interest Compound Interest

9 Interest Rate and Equivalence

 4.
Nominal and Effective Interest Rates
3

10 Interest Rate and Equivalence

 Nominal Interest Rates
Understanding
effective interest rates requires a defnition of a
nominal interest rate, r as the interest rate per period times the
number of periods.

.A nominal interest rate can be found for any time period that is
longer than the compounding period.
.Nominal
Nominal interest
4.5% per rates does not account for compounding.
0 quater
.For1.5%
example,
per month x 3an interest rate of 1.5% per month can be expressed
0 9% per semiannual
1 months
as : period
2 1.5% per month x 6 months. 0 36% per 2 years
1.5% per month x 6

Nominal interest rates obviously neglect 3 months.

compounding.
11 Interest Rate and Equivalence
 Nominal Interest Rates

Examples
1.5% per month
(1.5%)(24) = 36%
for 24 months
per 24 months @ 2-
years

1.5% per month (1.5%)(12

for 12 months
months) = 18%
per year

1.5% per month

(1.5%)(6 months) = 9%
for 6 months
per 6 months @
semiannual period

1% per week
for 1 year (1%)(52 weeks)
= 52% per year

12 Interest Rate and Equivalence

 Nominal Interest Rates

Compounding period (CP)

After the nominal rate has been calculated, the compounding
period (CP) must be included in the interest rate statement.

As an illustration, again consider the nominal rate of 1.5% per

month.

If we defne the CP as 1 month, the nominal rate statement is 18%

per year, compounded monthly, or 4.5% per quarter, compounded
monthly . 1.5% per month
(1.5%)(6 months) = 9%
for 6 months
per semi-annual period,
compounded monthly

13 Interest Rate and Equivalence

 Effective Interest Rates
An
effective interest rate i is a rate wherein the compounding of
interest is taken into account.
Effective rates are commonly expressed on an annual basis as an
effective annual rate; however, any time basis may be used.
The equation for converting a nominal interest rate into an
effective interest rate is:

i the effective interest rate for a certain period, e.g.

quarterly, annually, etc.
r the nominal interest rate for that period
Compoundingm the number of times interest is compounded in that same
frequency period
14 Interest Rate and Equivalence
 Effective Interest Rates

Example
Time
Compounding Period for period m must
frequency effective i for r equal
Annual annual year 1
Semi-annual annual year 2
year
Quarterly annual 4
annual
Monthly year 12
365
Daily annual year
6
Monthly semi- months 6
annual 12
Weekly quarterly quarter
15 Interest Rate and Equivalence
 Types of Effective Interest
Rates
Discrete Compounding Continuous
Compounding
The equation for converting a
The
equation for converting a
nominal interest rate into an nominal interest rate into an
effective interest rate is: effective interest rate is:

Example: For an interest rate of 12%

Example : For an interest rate of 8% per year compounded continuously,
per month, fnd the effective rate per fnd the nominal rate per quarter.
quarter.

16 Interest Rate and Equivalence

 Nominal and Effective Interest Rates

Focus on the Differences!

Nominal Rates Effective Rates
Interest rate per time period Interest rate is compounded
without regard to more frequently than once
compounding frequency per year
Format : r% per time period, Format : r% per time period,
t compounded m times a year.
Some nominal statements: Some statements indicating an
5% per 6-months effective rate:
1.5% per month for 12 months 15% per year, compounded
monthly
2% per month compounded
monthly
17
1% per Interest
week Rate and Equivalence
compounded
 Nominal and Effective Interest Rates

Focus on the Differences!

Nominal Rates
r = rate/period periods
Example: Rate is 1.5% per month.
Determine nominal rate per quarter,
year, and over 2 years
Effective Rates
Example: Credit card rate is 1.5% per
month compounded monthly.
Determine effective rate per quarter
and per year

Qtr: r = 1.5 3 mth = 4.5%

qrtr: r = 1.5 3 mth = 4.5% , m = 3
i = (1 + 0.045/3)3 1 = 4.57%
Year: r = 1.5 12 mth = 18% per qtr
= 4.5 4 qtr = 18%
year: r = 18% , m = 12
2 yrs: r =1.5 24 mth = 36% i = (1 + 0.18/12)12 - 1
18
= 19.6% Interest
per yearRate and Equivalence
 Effective Interest Rates

Example

For an interest rate of 10% per year compounded continuously,

fnd
i. the nominal rate per quarter
ii. the effective rate per month

19 Interest Rate and Equivalence

 Time Based Unit
The period of time over which the interest is expressed.
This is the t in the statement of r % per time period t , for example, 1%
per month.
Interest
The time unit of 1 year is by far the most common.
period (t)
It is assumed when not stated otherwise.

The shortest time unit over which interest is charged or earned.

This is defned by the compounding term in the interest rate statement,
Compoundi for example, 8% per year, compounded monthly.
ng period
(CP)
If CP is not stated, it is assumed to be the same as the interest period.

The number of times that compounding occurs within the interest period
t.
Compoundi If the compounding period CP and the time period t are the same, the
ng
compounding frequency is 1, for example, 1% per month, compounded
frequency
(m) monthly.

20 Interest Rate and Equivalence

 Final Exam Question

Example
You are given three different plans with different interest
charging. Three interest plans are presented:

a) 9% per year, compounded quarterly.

b) 3% per quarter, compounded quarterly.
c) 8.8% per year, compounded monthly.

If payments are made on a loan every 6

months. Which Bank has the lowest annual
interest rate?

21 Interest Rate and Equivalence

 4.
The Concept Equivalence
4

22 Interest Rate and Equivalence

 The Concept Equivalence

Terminology
Payment Period (PP), Tp - Length of time during which cash
flows are not recognized except as end of period cash flows.

Compounding Period (CP or interest period), Tc - Length of

time between compounding operations.

Interest Rate Period, T - Interest rates are stated as % per

time period. T is the time period.

Compounding frequency, m - the number of times that

compounding occurs within the time period of T.

23 Interest Rate and Equivalence

 The Concept Equivalence

Comparing PP vs. CP
PP =
CP
Often the frequency of cash flows
PP >
doesnt equal the frequency of
interest compounding. To correctly
CP
perform any equivalence computation,
it is essential that the PP and CP be
placed on the same time basis, and
PP <
that the interest rate and the number of CP
periods be adjusted accordingly.

24 Interest Rate and Equivalence

 The Concept Equivalence

Case 1: PP = CP
An engineer plans to borrow $3,000 from his company credit
union, to be paid in 24 equal monthly instalments. The credit
union charges interest at the rate of 1% per month on the
unpaid balance. How much money must the engineer repay
each month? P = $3,000
CP CP CP CP CP CP CP CP CP CP CP CP r = 1%
/month
PP = 1m
P P P P P P P P P P P P CP = 1m
P P P P P P P P P P P P
Solution:
Here both the payment and compound periods are equal to one
month.
Therefore, A = P(A/P, 1%, 24) = $3,000 (0.04707) = $141.21.
25 Interest Rate and Equivalence
 The Concept Equivalence

Case 2: PP > CP
An engineer deposits $1,000 in a savings account at the end of
each year. If the bank pays interest at the rate of 6% per year,
compounded quarterly, how much money will be accumulated
in the account after 5 years?
P = $1,000
CP CP CP CP r = 6% /y cq
PP = 1y
(12m)
P CP = 1q (3m)
P
Solution:
Here both the PP > CP, therefore,
F = 1,000(F/P,1.5%,16) + 1,000(F/P,1.5%,12)
+1,000(F/P,1.5%,8) +
26 1,000(F/P,1.5%,4) + 1,000 = $5,652.50. Interest Rate and Equivalence

Case 3: PP < CP
Interest is earned only by those
payments that have been
deposited or invested for the entire
interest period (CP).
usual mode of operation of banks
and lending institutions.
The following rules are applied:
All deposits made during an interest
period are moved to the end of the
interest period.
Situati
All withdrawals made during an
interest period are moved to the
on 1
beginning of the interest period.
Proceed as in the case where
interest periods and payment
27
The Concept Equivalence
Any amount of money that is
deposited between compounding
times earns compound interest.
Number of CPs per PP is now less
than 1.
Use the effective rate formula to
fnd effective rate. Use that rate
assuming compounding occurs at
that rate every PP.
Example:
Situati
PP=1 week; CP=1 quarter; r=3% per
on 2
quarter. Effective weekly i
%=(1.03)1/13-1.
Interest Rate and Equivalence
 The Concept Equivalence

Case 3: PP < CP

CP CP CP CP

P P P P P P
P P P P P P

28 Interest Rate and Equivalence

 4. Cash Flow-Diagram
5

29 Interest Rate and Equivalence

 Cash Flow-Diagram

Representation
Cash flows are inflows and outflows of money.
Every person or company has cash receipts revenue and income (inflows) E
and cash disbursements expenses or costs (outflows). x
a
Plus signs indicate cash inflows and minus signs
CASH indicate cash outflows.
OUTFLOW m
p
Engineering design
l
costs
e
Periodic maintenance
costs
Income taxes
CASH INFLOW
Salaries,
revenues
Income tax
savings
Receipts from
30 stock Interest Rate and Equivalence
 Cash Flow-Diagram

Representation
Cash flow estimates are just estimates.
Always some uncertainty involved in

Once cash inflow and outflow estimates are developed, the net
cash flow can be determined:
Net cash flow = cash inflows cash outflows

Important: End of period convention means that all cash flows

are assumed to occur at the end of an interest period.
When several receipts and disbursements occur within a given interest
period the net cash flow is assumed to occur at the end of the interest
period

31 Interest Rate and Equivalence

 Cash Flow-Diagram

Diagrams
Cash
flow diagram is an important tool in economic analysis.
It is a graphical representation of cash flows drawn on a time
scale.
In a cash flow diagram, is the present, and is end of time
period 1.
Year 1 Year 5

0 1 2 3 4 5

32 Interest Rate and Equivalence

 Cash Flow-Diagram

Diagrams - A sign convention is applied

Positive cash flows (inflows) are

normally drawn upward from the time
line
Cash flow, RM

1 2 3 4 Time

Negative cash flows (outflows) are

normally drawn downward from the
33
time line Interest Rate and Equivalence
 Cash Flow-Diagram

Example 1
Assume RM 5,000 is borrowed today and payments are RM
1,100 per year starting next year for 4 years. Draw the cash
flow diagram from the lenders and borrowers perspective.

A = RM 1,100/year RM
Borrowers
5,000
perspektif

0 1 2 3 4 Years
0 1 2 3 4 Years
Lenders
perspektif
-RM A = RM 1,100/year
5,000

34 Interest Rate and Equivalence

 Cash Flow-Diagram

Example 2
A mechanical device will cost RM RM 7000 + RM 4000
20,000 when purchased. =RM 11000

Maintenance will cost $1000 per A = RM 4000/year

year. The device will generate
revenues of RM 5, 000 per year for i = 15.5%
5 years. The salvage value is RM 7,
0 1 2 3 4 5 Years
000 after 5 years. If the rate of
return is estimated to be 15.5%
per year, construct the cash flow
diagram from the lenders -RM
20,000 A = positive cash flow
perspective. minus negative cash
flow

35 Interest Rate and Equivalence

 Summary

Chapter Summary by Farisha group

&
Final Year Question by GOODGRID

36 Interest Rate and Equivalence