Week 04

Example 4-19: Determining an Unknown

Annuity Amount
Two receipts of $1,000 each are desired at the EOYs 10 and 11. To make
these receipts possible, four EOY annuity amounts will be deposited in a
bank at EOYs 2, 3, 4, and 5. The bank’s interest rate (i) is 12% per year.
a) Draw a cash-flow diagram for this situation.
b) Determine the value of A that establishes equivalence in your cash-
flow diagram.
c) Determine the lump-sum value at the end of year 11 of the
completed cashflow diagram based on your answers to Parts (a)
and (b).
Example 4-19: Solution
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Example 4-19: Solution… p/3
Example 4-19: Solution… p/4
Nominal and Effective Interest Rates
• Very often the interest period, or time between successive compounding,
is less than one year (e.g., daily, weekly, monthly, or quarterly).
• It has become customary to quote interest rates on an annual basis,
followed by the compounding period if different from one year in length.
• For example, if the interest rate is 6% per interest period and the interest
period is six months, it is customary to speak of this rate as “12%
compounded semiannually.”
• Here the annual rate of interest is known as the nominal rate, 12% in this
case.
• A nominal interest rate is represented by r. But the actual (or effective)
annual rate on the principal is not 12%, but something greater, because
compounding occurs twice during the year.
Nominal and Effective Interest Rates… p/2
• The actual or exact rate of interest earned on the principal
during one year is known as the effective rate.
• It should be noted that effective interest rates are always
expressed on an annual basis, unless specifically stated
otherwise.
• In this text, the effective interest rate per year is customarily
designated by i and the nominal interest rate per year by r.
Nominal and Effective Interest Rates… p/3
• In engineering economy studies in which compounding is annual,
i = r.
• The relationship between effective interest, i, and nominal interest, r,
is

where M is the number of compounding periods per year. It is now

clear from Equation (4-32) why i > r when M > 1.
Nominal and Effective Interest Rates… p/4
Example 4-28: Effective Annual Interest Rate
A credit card company charges an interest rate of
1.375% per month on the unpaid balance of all
accounts. The annual interest rate, they claim, is
12(1.375%) = 16.5%. What is the effective rate of
interest per year being charged by the company?
Example 4-28: Solution
Example 4-29: Future Equivalent when Interest
Is Compounded Quarterly
Suppose that a $100 lump-sum amount is invested for
10 years at a nominal interest rate of 6% compounded
quarterly. How much is it worth at the end of the 10th
year?
Example 4-29: Solution
Example 4-30: Computing a Monthly Auto Payment

Stan Moneymaker has a bank loan for $10,000 to pay

for his new truck. This loan is to be repaid in equal end-
of-month installments for five years with a nominal
interest rate of 12% compounded monthly. What is the
amount of each payment?
Example 4-30: Solution