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Ch.4 : Nominal and Effective Interest Rates

Interest rate has been a constant, annual value Sometimes, interest rate compounded less than a year; monthly, weekly, quarterly introduce new term : nominal and effective interest rate

The statements

interest is compounded more than once a year effect of compounding more frequently is present NNoomiminnaall IInntteerreestst rraattee

an interest rate that does not include any consideration of compounding r = interest rate per period x no. of period

[4.1]

A nominal rate r may be stated for any time period : 1 year, 6 months, quarter, month, etc

Example,

the nominal rate of r = 1.5% per month is the same as :

 r = 1.5% per month x 24 month = 36% per 2-year period r = 1.5% per month x 12 month = 18% per year r = 1.5% per month x 0.231 month

= 0.346% per week

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is the actual rate that applies for a stated period of time

has the compounding frequency attached to the nominal rate statement

if not stated, it is assume to be the same as the time period of r, nominal and effective rates have the same value

The following are nominal rate statement; have different effective interest rate value due to the different compounding frequencies.

4% per year, compounded monthly 12% per year, compounded quarterly 9% per year, compounded daily

3% per quarter, compounded monthly 6% per 6 month, compounded weekly 3% per quarter, compounded daily

Determine the effective interest rate before performing engineering economy study

Three time-based units with an interest rate statement,

t tiimmee ppeerriioodd, the period over which the interest is expressed. This is the t in the statement

c coommppoouunnddiinngg ppeerriioodd (CP), the shortest time unit over which interest rate is charged or earned

c coommppoouunnddiinngg ffrreeqquueennccyy, the number of time that m compounding occurs within the time period t.

Example

The rate of 8% per year, compounded monthly it has time period t = 1 year

compounding period CP = 1 month

compounding frequency m = 12 times per year

A rate of 6% per year, compounded weekly

has t = 1 year

CP = 1 week

m = 52

The corresponding effective rate per CP is

Effective rate per CP =

r per time period t

m compounding periods per t = m r

Assume r = 9% per year, compounded monthly; then m = 12 from the equation CP = r/m, the effective rate = 9%/12 = 0.75% per month

Note changing the basic time period t does not alter the compounding period

EExxaammppllee 44 11

The different bank loan rates for the separate electric generation equipment projects are listed below. Determine the effective rate on the basis of the compounding period for each quote.

a) 9% per year, compounded quarterly

b) 9% per year, compounded monthly

c) 4.5% per 6-months, compounded weekly

Solution

Apply equation Effective rate per CP = r/m to determine the effective rate per CP for different compounding frequencies.

Nominal r% per t

compounding

period

m

Effective rate per CP

 a) 9% per year quarter 4 2.25% b) 9% per year month 12 0.75% c) 4.5% per 6- month week 26 0.17%

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Format of Rate Statement

Examples of Statement

Nominal rate stated, compounding period stated

Effective rate stated

Interest rate stated, no compounding period stated

8% per year, compounded quarterly

Effective 8.243% per year, compounded quarterly

8% per year,

2% per quarter

or

Find effective rate

Use effective rate directly

Rate is effective only for time period stated; find effective rate for all other time period

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The symbols used

 r = nominal interest rate per year m = no. of compounding periods per year

i = effective interest rate per compounding period (CP) = r/m i a = effective interest rate per year

Effective annual interest rates

treat nominal and effective interest rate parallels that of simple and compound interest Future worth for compound interest F = P(1 + i) n

Since interest may be compounded several times, replace i with i a ; the relation for F at the end of year 1:

FFuuttuurree wwoorrtthh ccaallccuullaattiioonn aatt aa rarattee ii,, ccoommppoouunnddeedd mm ttiimmeess

iinn aa yyeeaarr

P(1+i) m = P(1+i a ) P(1 + i) m-1

P(1 + i) m-2  P(1 + i) 2

P(1 + i)  P

 i i i 1 2 3

P(1 + i) 3 i

m – 2

i

m – 1

i

m

Future worth amounts

Effective i per compounding period

Compounding period

the rate i per CP must be compounded through all m periods,

F = P(1 + i) m

[4.4]

If, P = \$, then by equating F = (1 + i) m ,and F = 1 + i a , the effective annual interest rate formula for i a can be derived 1 + i a = (1+ i) m

i a = (1 + i) m 1

[4.5]

If the effective annual rate, i a and compounding frequency m are known, the effective interest rate per compounding period is,

i = (1 + i a ) 1/m – 1

[4.6]

to determine the nominal annual rate r, using the definition of i stated above, namely, i = r/m,

r% per year = (i% per CP)(no. of Cps per

year) = (i)(m)

[4.7]

EExxaammppllee 44 22

Jacki obtained a new credit card from a national bank, MBNA, with a stated rate of 18% per year, compounded monthly. For a \$1000 balance at the beginning of the year, find the effective annual rate and the total amount owed to MBNA after 1 year, provided no payments are made during the year.

SSoolluuttiioonn

There are 12 compounding periods per year. Thus, m = 12 and

i = 18%/12 = 1.5% per month

For a \$1000 balance that is not reduced during the year, apply eq. [4.5] then [4.3] to provide Jacki with the information.

i a = (1 + 0.015) 12 -1 = 1.19562 -1 = 0.19562 F = \$1000(1.19562) = \$1195.62

Jacki will pay 19.562% or \$195.62 plus the \$1000 balance, for the use of the bank's money during the year

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known compounding period (CP)

new term : payment period (PP), the frequency of the payments or receipts

to evaluate cash flow with PP < 1 year, effective interest rate over PP must be used

EEffffeeccttiivvee ii == ((11 ++ rr//mm)) mm 11

where:

[[44 88]]

r

m

= nominal interest rate per payment period (PP)

= number of compounding periods per payment period (CP per PP)

Example A company deposits money each month into an account that pays a nominal interest rate of 14 % per year, compounded semi- annually, the payment period is 1 months while the compounding period is 6 months

r = nominal 14% per year, compounded semiannually CP

6 months CP

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

EExxaammppllee 44 44

Visteon, a spin-off company of Ford Motor Company, supplies major automobile components to auto manufacturers worldwide and is Ford's largest supplier. An engineer is on a Visteon committee to evaluate bids for new-generation coordinate measuring machinery to be directly linked to the automated manufacturing of high- precision components. Three vendor bids include the interest rate on the next page. Visteon will make payments on a semiannual basis only.

The engineer is confused about the effective interest rates – what they are annually and over the payment period of 6-months.

Bid #1:

Bid #2:

Bid #3:

9% per year, compounded quarterly 3% per quarter, compounded quarterly 8.8% per year, compounded monthly

(a) Determine the effective rate for each bid

on the basis of semiannual payments, and construct cash flow diagram (b) What are the effective annual rates? There are to be part of the final bid selection

c) Which bid has the lowest effective annual rate ?

Solution

(a) Set the payment period (PP) at 6-month, PP = 6 months

 r = 9% per year = 4.5% per 6-months m = 2 quarters per 6-months

Effective i% per 6-months =

1 0.45

2

2

- 1

= 1.0455 – 1 = 4.55%

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 Bid Semiannual Rates Nominal per 6 Months, r CP per PP, m Effective i Equation [4.8] Nominal per Year, r Annual Rates CP per Year, m Effective i Equation [4.8] #1 4.50% 2 4.55% 9.00% 4 9.31% #2 6.00% 2 6.09% 12.00% 4 12.55% #3 4.40% 6 4.48% 8.80% 12 9.16%

Cash flow diagram for bid 1 and bid 2 CP CP 1quarter 1quarter 1 2 PP

6 Months

CP 1quarter

3

CP

1quarter

4

PP

6 Months

Cash flow diagram for bid 3

1 2 3 4 5 PP

6 Months

CP = 1 month

6

7 8

9

10

11

PP

6 Months

12

b) For the effective annual rate, the time basis in Equation [4.8] is 1 year. This is the same as PP = 1 year. For bid #1,

r = 9% per year

m = 4 quarters per year

Effective i% per year =

1 0.09

4

4 1

= 9.31%

c) Bid #3 includes the lowest effective annual rate of 9.16%, which is equivalent to an effective semiannual rate of 4.48%

Comment

The effective rates for bid #2 only may be found directly in tables 4-3. For the effective semiannual rate, look at the nominal 6% under m = 2, which is the number of quarters per 6 months. The effective semiannual rate is 6.09%. Similarly, for the nominal 12% rate, there are m = 4 quarters per year, so effective annual i = 12.551%. Although Table 4-3 was originally designed for nominal annual rates, it is correct for other nominal rate periods, provided the appropriate m value is included in the column headings.

EExxaammppllee 44 55

A dot-com company plans to place money in a new venture capital fund that currently returns 18% per year, compounded daily. What effective rate is this (a) yearly and (b) semiannually?

Solution

(a) Use Eq. [4.8], with r = 0.18 and m = 365

Effective i% per year =

1 0.18

365

=19.716%

365 1

(b) Here r = 0.09% per 6-months and m = 182 days

Effective i% per 6 months =

1 0.09

182

= 9.415%

182 1

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Real-world situation, interest rate vary over time

Depends upon financial health, market sector, national and international economy, forces of inflation, and other

Loan rates may increase

When P,F, and A values calculated using a constant interest rate, fluctuation in i are neglected If the variation in i is large, the equivalent values will be different

To determine P value for F t at different i values for each year t, assume annual compounding. Define i t = effective annual interest rate for year t (t = years 1 to n)

t

To determine the present worth, calculate P of each F t value, using the applicable i t , and

sum the results. P = F 1 (P/F,i 1 ,1) + F 2 (P/F,i 1 ,1)(P/F,i 2 ,1) +

+ F n (P/F,i 1 ,1)(P/F,i 2 ,1)

(P/F,i n ,1)

[4.13]

When only single amounts P and F are involved,

P = F n (P/F,i 1 ,1)(P/F,i 2 ,1)

(P/F,i n ,1)

[4.14]

If A is needed find P substitute symbol A for each F t symbol equivalent P has been determined, only one unknown – A

If there is a cash flow in year 0, interest rate vary annually; this cash flow must be included to determine P

For the computation of equivalent uniform series A, also include the initial cash flow at t = 0

Insert the factor value (P/F,i 0 ,0), which have value of 1.00

EExxaammppllee 44 1313

CE, inc., leases large earth tunneling equipment. The net profit from equipment for each of the last 4 years has been decreasing, as shown below. Also shown are the annual rates of return on invested capital. The return has been increasing. Determine the present worth P and equivalent uniform series A of the net profit series. Take the annual variation of rates of return into account.

Year

1

2

3

4

Net Profit Annual Rate

\$70,000.00

7.00%

\$70,000.00

7.00%

\$35,000.00

9.00%

\$25,000.00

10.00%

Solution Figure below shows the cash flows, rates for each year, and the equivalent P and A. \$70,000

0   1

7% P = ?

2

7%

\$35,000 3 \$25,000
4

9%

10%

A = ? 0
1
2
3
4
7%
7%
9%
10%
\$172,816

Equation [4.13] is used to calculate P. Since for both years1 and 2 the net profit is \$70,000 and the annual rate is 7 %, the P/A factor can be used for these 2 years only.

P = [70(P/A,7%,2) + 35(P/F,7%,2)(P/F,9%,1) + 25(P/F,7%,2)(P/F,9%,1)(P/F,10%,1)](1000)

= [70(1.8080) + 35(0.8013) +

25(0.7284)](1000)

= \$172,816

To determine an equivalent annual series, substitute the symbol A for all net profit values on the right side of Equation [4.15], set it equal to P = \$172,816 and solve for A. This equation accounts for the varying i values each year.

\$172,816 = A[(1.8080) + (0.8013) + (0.7284)] = A[3.3377] A = \$51,777