Engineering Economy

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IE307

Nominal and Effective

Interest Rates
Industrial and Manufacturing Systems Engineering Department

Nominal and Effective Interest Rate Statements

➢ Nominal interest rate (r) is an interest rate that does not account for compounding, By
definition,
r = interest rate per time period × number of periods
=i×m
For example, the interest rate of 1.5% per month is the same the nominal rates 18%(1.5% x
12) per year, compounded monthly and nominal rate 4.5% (1.5% x 3) per quarter,
compounded monthly.
➢ Compounding period (CP) is used to determine the period of compounding the amounts of
money.If the CP is not mentioned, it is considered to be as the same period of interest rate .
➢ Effective interest rate(i) take compounding of interest into account.
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Nominal and Effective Interest Rate Statements

➢ There time-based units associated with an interest rate statement

• Interest period (t):The period of time over which the interest is expressed.
• Compounding period (CP) :the shortest time unit over which interest is charged or earned.
• Compounding frequency (m):the number of times that compounding occurs within the
interest period t.
➢ For example, if r = 18% per year, compounded monthly. That means:
• t = 1 year 18%
• CP = 1month
1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5%

• m= 12 times per year.

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Nominal and Effective Interest Rate Statements

➢ An effective rate may not always include the compounding period in the statement, especially
when it equals to the interest rate period.
➢ All interest formulas, factors, and tabulated values must use an effective interest rate to properly
account for the time value of money. In previous chapters, all interest rates had t and CP values of
1 year, so the compounding frequency was always m=1. This made them all effective rates,
because the interest period and compounding period were the same.
➢ An effective rate can be determined from a nominal rate by using the relation
r % per time period t 𝒓
Effective rate per CP = =
m compounding periods per t 𝒎
➢ Note that changing the interest period t does not alter the compounding period, which is 1 month in this
illustration. Therefore, r = 9% per year, compounded monthly, and r = 4.5% per 6 months,
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compounded monthly, are two expression of the same interest rate.
Industrial and Manufacturing Systems Engineering Department

Nominal and Effective Interest Rate Statements

➢ Example:Effective rate per CP

a) 9% per year, compounded quarterly
b) 9% per year, compounded monthly
c) 4.5% per 6 months, compounded weekly

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Effective Annual Interest Rates

➢ Effective annual interest rate (ia )

𝒎
ia = 1 + 𝑖 −1
𝑟 𝒎
= 1+ −1
𝑚

➢ Effective interest rate per compounding period (i)

𝟏/𝒎
𝐢 = 𝟏 + 𝒊𝒂 −𝟏
Where:
r = nominal interest rate per year
m = number of compounding periods per year

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Effective Annual Interest Rates

r = 18% per year, compounding Cp-ly

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Effective Annual Interest Rates

➢ Effective Annual Interest Rates for Selected Nominal Rates

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Effective Interest Rates for Any Time Period

𝑟 𝒎
Effective i per time period = 1 + −1
𝑚
Where:
i = effective rate for specified time period (say, semiannual)
r = nominal interest rate for same time period (semiannual)
m = number of times interest is compounded per stated time period (times per 6
months)

The term r/m is always the effective interest rate over a compounding period CP, and m is
always the number of times that interest is compounded per the time period on the left of the
Equation.
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Effective Interest Rates for Any Time Period

➢ Example:
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) r = 0.18 per year and m = 365 days per year
365
0.18
𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝒊% 𝐩𝐞𝐫 year = 1 + − 1 = 9.716%
365
b) r = 0.09 per 6 months and m = 182 days per 6 months
365
0.09
𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝒊% per 6 months = 1 + − 1 = 9.415%
182
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Equivalence Relations: PP and CP

➢ The payment period (PP) is the length of time between cash flows (inflows or outflows). It is
important to determine if PP = CP, PP ˃ CP, or PP ˂ CP.
➢ If a company deposits money each month into an account that earns at the nominal rate of 8%
per year, compounded semiannually, the cash flow deposits define a payment period of 1 month
and the nominal interest rate defines a compounding period of 6 months.
➢ In the diagram below, the compounding period (CP) is semiannual and the payment period (PP)
is monthly.

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Equivalence Relations: PP and CP

➢ It is essential that the time periods of the interest rate and the payment period be on the same
time basis.
➢ The next two sections describe procedures to determine correct i and n values for engineering
economy factors. First, compare the length of PP and CP, then identify the cash flows as only
single amounts ( P and F ) or as a series ( A , G , or g ).

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Equivalence Relations: Single Amounts with PP ≥ CP

➢ When only single-amount cash flows are involved, there are two equally correct ways to determine i and n
for P/F and F/P factors. Method 1 is easier to apply, because the interest tables in the back of the text
can usually provide the factor value. Method 2 likely requires a factor formula calculation, because the
resulting effective interest rate is not an integer.
➢ Method 1: Determine the effective interest rate over the compounding period CP , and set n equal
to the number of compounding periods between P and F . The relations to calculate P and F are
P = F (P/F, effective i % per CP, total number of periods n)
F = P (F/P, effective i % per CP, total number of periods n)

➢ For example, assume that the stated credit card rate is nominal 15% per year, compounded monthly.
Here CP is 1 month. To find P or F over a 2-year span, calculate the effective monthly rate of (15%/12)=
1.25% and the total months of 2(12) = 24. Then 1.25% and 24 are used in the P/F and F/P factors.
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Equivalence Relations: Single Amounts with PP≥ CP

➢ Method 2: Determine the effective interest rate for the time period t of the nominal rate,
and set n equal to the total number of periods, using this same time period.
➢ For a credit card rate of 15% per year, compounded monthly, the time period t is 1 year. The
effective rate over 1 year and the n values are

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0.15
𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝒊% 𝐩𝐞𝐫 year = 1 + − 1 = 6.076% n = 2 years
12

Note :
( P/F ,1.25%,24) = 0.7422 =( P/F ,16.076%,2) = 0.7422

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Equivalence Relations: Single Amounts with PP≥ CP

➢ Example:
Over the past 10 years, a company has placed varying sums of money into a special capital
accumulation fund. Find the amount in the account now (after 10 years) at an interest rate of
12% per year, compounded semiannually. The following is the CFD in $1000 units.

Solution
Method 1: CP is semiannual, effective rate i= 6% per 6-month period
n = (2)(number of years) semiannual periods =20,12 & 8 periods.
F =1000(F/P,6%,20) + 3000(F/P,6%,12) + 1500(F/P,6%,8)
F =1000(3.2071) + 3000(2.0122) +1500(1.5938)
$11,634 ($11.634 million)
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Equivalence Relations: Single Amounts with PP≥ CP

➢ Method 2: Express the effective annual rate (ia), based on CP= 6 months.
2
0.12
𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝒊% 𝐩𝐞𝐫 year = 1 + − 1 = 12.36%
2

The n value is the actual number of years. Use the factor formula (F/P, i, n) = (1.1236)n
F = 1000(F/P,12.36%,10) + 3000(F/P,12.36%,6) + 1500(F/P,12.36%,4)
F =1000(3.2071) + 3000(2.0122) +1500(1.5938)
= $11,634 ($11.634 million)

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Equivalence Relations: Series with PP≥ CP

➢ When uniform or gradient series are included in the cash flow sequence, the procedure is
basically the same as method 2 above, except that PP is now defined by the length of time
between cash flows. This also establishes the time unit of the effective interest rate.
➢ For example, if cash flows occur on a quarterly basis, PP is 1 quarter and the effective
quarterly rate is necessary. The n value is the total number of quarters. If PP is a quarter, 5
years translates to an n value of 20 quarters.
➢ When cash flows involve a series (i.e., A , G , g ) and the payment period equals or exceeds the
compounding period in length:
✓ find the effective i per PP.
✓ Determine n as the total number of payment periods.
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Equivalence Relations: Series with PP≥ CP

➢ Example:
For the past 7 years, Excelon Energy has paid $500 every 6 months for a software maintenance
contract. What is the equivalent total amount after the last payment, if these funds are taken from
a pool that has been returning 8% per year, compounded quarterly?
Solution:
PP= 6 months, CP = 3 months, r = 4% per 6-month,
m = 2 quarters per semiannual period.
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0.04
𝑬𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝒊% 𝐩𝐞𝐫 semiannual = 1 + − 1 = 4.04%
2
The total number of semiannual payment periods is n = 2(7) = 14.
The relation for F is:
F = A(F/A,4.04%,14) =500)18.3422( =$9171.09 18
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