ENGINEERING ECONOMICS

Presented by
Dr. Zahoor

Lecture 5
NOMINAL AND EFFECTIVE
INTEREST RATE
 Nominal and Effective Interest Rate

Ten thousand dollars is borrowed for two years at an interest rate of

24% per year compounded quarterly.
If this same sum of money could be borrowed for the same period at the same
interest rate of 24% per year compounded annually, how much could be
saved in interest charges?
 Nominal and Effective Interest Rate
Effective Interest Rate
Nominal Interest Rate
Ten thousand dollars is borrowed for two years at an interest rate of
24% per year compounded quarterly.
If this same sum of money could be borrowed for the same period at the same
interest rate of 24% per year compounded annually, how much could be
saved in interest charges?
 Nominal and Effective Interest Rate
Effective Interest Rate
Nominal Interest Rate
Ten thousand dollars is borrowed for two years at an interest rate of
24% per year compounded quarterly.
If this same sum of money could be borrowed for the same period at the same
interest rate of 24% per year compounded annually, how much could be
saved in interest charges?

interest charges for quarterly compounding: Compounding is not less

$10,000(1+24%/4)2x4 -$10,000 = $5938.48 important than interest

interest charges for annually compounding: You have to know all the
$10,000(1+24%)2 - $10,000 = $5376.00 information to make a
good decision
Savings:
$5938.48 - $5376 = $562.48
 Nominal and Effective Interest Rate

A bank pays 5% compounded semi-annually. If you deposit

$1000, how much will it grow to by the end of the year?

The bank pays 2.5% each six months.

You get 2.5% interest per period for two periods.

F= 1000(1+0.05/2)1x2 = $1,050.60
1000  1000(1+0.025)  1,025  1025(1.025) = $1,050.60
With i = 0.05/2, r = 0.05,
P  (1 + i) P  (1+r/2)2  (1+ 0.05/2)2  (1.050625) 
(1+.050625)  (1+5.0625%)
Effective interest rate = ia=5.0625%
 Nominal and Effective Interest Rate

r = 5% is called the nominal interest rate per interest period

(usually one year)
i = 2.5 % is called the effective interest rate per interest period
ia = 5.0625% is called the effective interest rate per year

In the example: m = 2 is the number of compounding subperiods

per time period.
 Nominal and Effective Interest Rate

r = 5% is called the nominal interest rate per interest period

(usually one year)
i = 2.5 % is called the effective interest rate per interest period
ia = 5.0625% is called the effective interest rate per year

In the example: m = 2 is the number of compounding subperiods

per time period.
ia = (1 + r/m)m – 1 = (1 + i)m – 1
ia = (1.050625) – 1 = (1.025)2 – 1 = (1+0.05/2)2 – 1
The term i we have used up to now is more precisely defined as the effective interest rate per interest period
If the interest period is one year . (m = 1) then i = r.

r = nominal interest rate per year

m = number of compounding sub-periods per year
i = r/m = effective interest rate per compounding sub-period.
 Nominal and Effective Interest Rate
Example A bank pays 1.5% interest every three months.
What are the nominal and effective interest rates per year?

Solution:
Nominal interest rate per year is

r = 4  1.5% = 6% a year

Effective interest rate per year:

ia = (1 + r/m)m – 1 = (1.015)4 – 1 = 0.06136  6.14% a year.

 Nominal and Effective Interest Rate
Table Nominal & Effective Interest expressed in percent

Effective rates, ia = (1 + r/m)m - 1

Nominal rate Yearly Semi- Monthly Daily Continuously
ann.
r m=1 m=2 m = 12 m = 365
1 1.0000 1.0025 1.0046 1.0050 1.0050
2 2.0000 2.0100 2.0184 2.0201 2.0201
3 3.0000 3.0225 3.0416 3.0453 3.0455
4 4.0000 4.0400 4.0742 4.0808 4.0811
5 5.0000 5.0625 5.1162 5.1267 5.1271
6 6.0000 6.0900 6.1678 6.1831 6.1837
8 8.0000 8.1600 8.3000 8.3278 8.3287
10 10.0000 10.2500 10.4713 10.5156 10.5171
15 15.0000 15.5625 16.0755 16.1798 16.1834
25 25.0000 26.5625 28.0732 28.3916 28.4025

Remark. The formula used for the continuous rate is er - 1, expressed

in percent. It is the limit of (1 + r/m)m as m goes to infinity.
 Nominal and Effective Interest Rate
Example Jamshed lends money on the following terms. “If I give
you 50 dollars on Monday, then you owe me 60 dollars the
following Monday.”

1.What is the nominal rate, r?

We first note Jamshed charges i = 20% a week,

since 60 = (1+i) 50  i = 0.2. Note we have solved
F = 50(F/P,i,1) for i.
We know m = 52, so r = 52  i = 10.4, or 1,040% a year.

2. What is the effective rate, ia ?

From ia = (1 + r/m)m – 1, we have ia = (1+10.4/52)52 – 1  13,104.
This means about 1,310,400 % a year.
 Nominal and Effective Interest Rate

Suppose Jamshed can keep the $50, as well as all the money he
receives in payments, out in loans at all times?
How much would Jamshed have at the end of the year?
We use F = P(1+i)n to get F = 50(1.2)52  $655,232
(not bad, but probably illegal)
 Nominal and Effective Interest Rate
Example Salman deposits $5000 in a saving account paying 8%
nominal interest, compounded quarterly. He wants to withdraw
the money in five equal yearly sums, beginning Dec. 31 of the
first year. How much should he withdraw each year?
 Nominal and Effective Interest Rate
Example Salman deposits $5000 in a saving account paying 8%
nominal interest, compounded quarterly. He wants to withdraw
the money in five equal yearly sums, beginning Dec. 31 of the
first year. How much should he withdraw each year?

effective interest is i = 2% = r/4 = 8% / 4 quarterly, and there are

20 periods.

W W W W W

i = 2%, n = 20

$5000
 Nominal and Effective Interest Rate
The withdrawal periods and the compounding periods are not
the same. If we want to use the formula
A = P (A/P,i,n)
So, we must find a way to put the problem into an equivalent
form where all the periods are the same.

Solution 1. Suppose we withdraw an amount A quarterly.

(We don’t, but suppose we do). We compute

A = P (A/P,i,n) = 5000 (A/P,2%,20) = 5000 (0.0612) =

$306.

i = 2%, n = 20
$5000
 Nominal and Effective Interest Rate
Now consider the following:
A
W W W W

i = 2%, n = 4
W

Consider a one-year period:

This is now in a standard form that repeats every year.

W = A(F/A,i,n) = 306 (F/A,2%,4) = 306 (4.122) = $1260.

Salman should withdraw $1260 at the end of each year.

 Nominal and Effective Interest Rate
Solution 2 (Probably the easiest way)

ia = 8.24%, n = 5
$5000

ia = (1 + r/m)m – 1 = (1 + i)m – 1 = (1.02)4 – 1 = 0.0824  8.24%

Now use:
W = P(A/P,8.24%,5) = P {[i (1+i)n]/[(1+i)n – 1]} = 5000(0.252)
= $1260 per year.
 Summary Notation
i: effective interest rate per interest period (stated as a
decimal)
n: number of interest periods
P: present sum of money
F: future sum of money: an amount, n interest periods from the
present, that is equivalent to P with interest rate i
A: end-of-period cash receipt or disbursement amount in a
uniform series, continuing for n periods, the entire series
equivalent to P or F at interest rate i.
r: nominal interest rate per interest period (usually one year)
ia: effective interest rate per year (annum)
m: number of compounding sub-periods per period
 Summary: Formulas
• Single Payment formulas:
Compound amount: F = P (1+i)n = P (F/P,i,n)
Present worth: P = F (1+i)-n = F (P/F,i,n)

• Uniform Series Formulas

Compound Amount: F = A{[(1+i)n –1]/i} =A
(F/A,i,n)
Sinking Fund: A = F {i/[(1+i)n –1]} =F
(A/F,i,n)
Capital Recovery: A = P {[i(1+i)n]/[(1+i)n – 1] =P
(A/P,i,n)
Present Worth: P = A{[(1+i)n – 1]/[i(1+i)n]} =A
(P/A,i,n)
 Summary: Formulas
• Nominal interest rate per year, r: the annual interest rate
without considering the effect of any compounding

• Effective interest rate per year, ia:

ia = (1 + r/m)m – 1 = (1+i)m – 1 with i = r/m

• Continuous compounding, :
r – one-period interest rate, n – number of periods
(P/F,r,n)inf= e-rn
(F/P,r,n)inf= ern
Solving for an Unknown
Number of Years
 Number of years n is unknown

• Some problems require solving for a number of periods (NPER)

given the other parameters

• We can always solve for n in closed form…

 1   i(1  i)n 
PF n 
A P 
  (1  i)  1
n
 (1 i ) 

 i 
AF 
 (1  i ) n
 1 
 Example: Solving for n

• How long will it take for $1,000 to double in value, at an interest

rate of 5%?

Fn = $2000

0 1 2 ... . . . ……. n
i = 5%/year; n is unknown!

P = $1,000
 Example (continued)
Fn = $2000

0 1 2 ... . . . ……. n
i = 5%/year; n is unknown!

P = $1,000

• Fn = 1000 (F/P, 5%, n)

2000 = 1000 (1.05)n
We can solve for n
 Example (continued)

• (1.05)n = 2000/1000
• n ln(1.05) = ln(2)
• n = ln(2)/ln(1.05)
• n = 0.693147/0.04879 = 14.2067 years
• With compounding every year:
• It will take 15 years to amass $2,000
• (Actually, a little more than $2,000!)
SOLVING FOR AN UNKNOWN
INTEREST RATE
 Uncertain interest rates

• It may be of interest to determine the value of i that makes

two streams of payments equivalent
• Why?
– Compare a series of payments to a fixed interest rate
– Determine attractiveness of the payments
– Provide a simple summary measure
 Example: Solving for i

• Assume you can invest $3,000 now in a friend’s business,

and will get paid back $5,000 in 5 years:
• For what interest rate or “internal rate of return” (IRR) are
these amounts equivalent?

$5,000

0 1 2 3 4 5

$3,000
 Example (continued)

$5,000

0 1 2 3 4 5

$3,000

• F = P (1+i)n
• 5,000 = 3,000 (1+i)5
• (1+i)5 = 5,000/3000 = 1.6667
• (1+i) = 1.66670.20 = 1.1076
• i = 1.1076 – 1 = 0.1076 = 10.76%
• This project is equivalent to earning 10.76% per year
 Uncertain interest rates
• If there is an annual series of payments, this gets more complicated:

• Can find n (using logarithms), but not i!

– Because i appears twice:
• Once with an exponent
• Once without
 Interest rate i is unknown

• Usually, you will need some other approach:

• Trial and error (try different values of i until you converge
on the unknown interest rate)
• Use look-up tables at back of textbook, and interpolate
(needed for exams!)
• Use IRR function in Excel
 Uncertain interest rates

• How to solve?
• Two options
– Trial and error:
• Try different values of i until you converge
• I.e., until P = A [1 - 1/(1+i)n]/i
– Use look-up tables
• (e.g., tables at back of textbook)
and interpolate
 Interest rate i is unknown

• When annual payments are involved:

• Interpolation or trial and error must be used

 i(1  i)n   i 
A P  AF 
 (1  i)  1
n
 (1  i ) n
 1 
 Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?

0 1 2 3 4 5

Interest is compounded yearly
P = 400(P/F,12%,3) + 600(P/F,12%,5)
= 400 (0.7118) + 600 (0.5674)
= 284.72 + 340.44 = $625.16
$400
$600
Interest is compounded monthly
P = 400(P/F, 12%/12, 3*12) +
600(P/F, 12%/12, 5*12)
= 400(P/F, 1%, 36) + 600(P/F, 1%, 60)
= 400 (0.6989) + 600 (0.5504)
= 279.56 + 330.24 = $609.80

34
 Assignment - 1
Q.1
A bank pays 4.5% interest after every 3 months. What are the
nominal and effective interest rates per year?
ia = (1 + r/m)m – 1, i=r/m
Q.2
You need $1200 to pay a debt after 6 years. After 4 more years,
you need $950 more to pay another debt. How much should
you put in the bank today to meet these two needs if the bank
pays 9.5% per year?
Q.3
For the diagram given below, find P? i=0.25%
P=?
240 240 240 240 350

0 1 2 3 4 5 6 7th year
36
 Summary: Formulas
• Single Payment formulas:
Compound amount: F = P (1+i)n = P (F/P,i,n)
Present worth: P = F (1+i)-n = F (P/F,i,n)

• Uniform Series Formulas

Compound Amount: F = A{[(1+i)n –1]/i} =A
(F/A,i,n)
Sinking Fund: A = F {i/[(1+i)n –1]} =F
(A/F,i,n)
Capital Recovery: A = P {[i(1+i)n]/[(1+i)n – 1] =P
(A/P,i,n)
Present Worth: P = A{[(1+i)n – 1]/[i(1+i)n]} =A
(P/A,i,n)
Single Payment formulas:

Compound amount: F = P (1+i)n = P (F/P,i,n)

Present worth: P = F (1+i)-n = F (P/F,i,n)

Uniform Series Formulas

Compound Amount: F = A [{(1+i)n –1} / i] = A (F/A,i,n)

Sinking Fund: A = F [i / {(1+i)n –1}] = F (A/F,i,n)

Capital Recovery: A = P [i(1+i)n] / [(1+i)n – 1] = P (A/P,i,n)

Present Worth: P = A [(1+i)n – 1] / [i(1+i)n] = A (P/A,i,n)