ENGR 3360U Winter 2014

Unit 4.7-8
Finding i%, n, Continuous Compounding
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01

Unit 4 Interest and Equivalence

Change Record
2014-I-01 Initial Creation
Text references: Chapters 3 and 4

4-2

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

4.7 Finding an Unknown Interest Rate

Class of problems where the interest rate, i
%, is the unknown value
For simple, single payment problems (i.e., P
and F only), solving for i% given the other
parameters is not difficult
For annuity and gradient type problems,
solving for i% can be tedious
Trial and error method
Apply spreadsheet models
4-3

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

The IRR Spreadsheet Function

Define the total cash flow as a column of
values within Excel
Apply the IRR function:
=IRR(first_cell:last_cell, guess value)

If the cash flow series is an A value then

apply the RATE function:
=RATE(number_years, A,P,F)

4-4

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Example 4.18
Fred buys a new car with $0 down. Total cost is $15,732 and Fred
has to pay 48 monthly payments of $398. What effective annual
interest rate is he paying?
Solution 1 15,732 = 398(P/A, i, 48) or (P/A, i, 48) = 39.5276
At 1% (P/A, 1%, 48) = 40.185 At .75%, (P/A, .75%, 48) = 37.974
So i = (40.185-39.5276)/(40.185-37.974)*0.25 + 0.75 = 0.82%
Annualized rate = (1.00082)12 - 1 = 10.3%
Solution 2 RATE(48, -398, 15732, 0) = 0.82

4-5

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Determination of an Unknown Number of Years

Class of problems where the number of time
periods (years) is the unknown
In single payment type problems, solving for
n is straight forward
In other types of cash flow profiles, solving
for n requires trial and error or spreadsheet
In Excel, given A, P, and/or F, and i% values
apply:
=NPER(i%,A,P,F) to return the value of n

4-6

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

4.8 Nominal and Effective Interest Rates

Nominal Interest Rate (r) in name only:

Interest rate without consideration of

compounding (not used in analysis)

Effective Interest Rate (r):

4-7

Interest rate that takes compounding into

consideration (used in analysis)

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Effective Interest
Example: 12% per year compounded monthly
Nominal Interest Rate:
r =12%/year compounded monthly

Effective Monthly Rate (i):

i = r/m
where m = compounding period
i = 0.12/12 = 1% per month effective!

Effective Yearly Rate (i):

i = (1+r/m)m 1
i = (1+0.1)12 1 = 12.68%/year effective!
*Note: that is 0.68% higher than nominal at 12% per year c.m.

4-8

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Continuous Compounding
The number of compounding periods depends on the number of
subdivisions.
A nominal interest rate of 12%/year compounded:

4-9

m = 1: yearly
m = 2: semi-annually
m = 4: quarterly
m = 52: weekly
yearly)
m = 365: daily
yearly)
m = 525600: hourly

(equals 12% effective yearly)

(equals 12.360% effective yearly)
(equals 12.551% effective yearly)
(equals 12.734% effective
(equals 12.747% effective
(equals 12.749% effective yearly)

Note: we are approaching a limit!

For infinite compounding periods
(continuously compounded):
i = er - 1

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Basic Formulae for compounding

(A/F,r,n)= (er 1)/(ern 1)
(A/P,r,n) = ern (er 1)/(ern 1)
(F/A,r,n) = (ern-1)/(er 1)
(P/A,r,n) = (ern 1)/(ern(er 1))

4-10

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Summary
Interest factors exist to aid in determining
economic equivalence of various cash flow
patterns
Notation is introduced that is applied
throughout the remainder of the text
Introduction of important Excel spreadsheet
financial functions to aid in evaluation of
engineering economy problems

4-11

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Summary, contd.
Gradients

Arithmetic requires two calculations:

4-12

Base Series and Gradient

e.g., P = A(P/A, i%, n) + G(P/G, i%, n)
P is one period to the left of the base series and two
periods to the left of the first gradient.

Geometric requires one calculation:

P = A1(P/A, g, i, n)

P is one period to the left of A1

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Summary, contd.
Nominal means in name only and cannot
be used for calculation.

Convert to an effective rate per period.

Compounding periods can be increased to

infinity; called continuous compounding.
There are spreadsheet functions for a
number of different economic factors.

4-13

See textbook for more detail.

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco