MODULE 3

THE TIME VALUE

OF MONEY
(PART 5)
NOMINAL AND EFFECTIVE INTEREST RATES
Nominal Interest Rate
• denoted by r; specifies the rate of interest
and a number of interest periods in one year
• the stated annual interest rate for rate
compounded more frequently than one year
• e.g. 20% compounded semiannually
• r = 20% ; M = number of compounding
periods in one year; M = 2
NOMINAL AND EFFECTIVE INTEREST RATES
•• Effective
Effective Interest
Interest Rate
Rate -- ii -- For
For rates
rates compounded
compounded
more
more frequently
frequently than
than one
one year;
year;
•• the
the actual
actual interest
interest rate
rate per
per year
year

ii == (( 11 ++ rr // M
M ))MM -- 11 == (( F
F // P,
P, rr // M,
M, M
M )) -1
-1
–– M
M -- the
the number
number of
of compounding
compounding periods
periods per
per year
year

•• Annual
Annual Percentage
Percentage Rate
Rate -- APR
APR -- percentage
percentage rate
rate per
per
period
period times
times number
number of
of periods.
periods.
–– APR
APR == (r
(r /M)
/M) xx M
M
Take note:
 Nominal
Nominal interest
interest rate
rate rr is
is an
an interest
interest rate
rate that
that does
does not
not
account
account for for compounding;
compounding; “r% “r% per
per time
time period”
period”
 By
By definition,
definition,
rr == interest
interest rate
rate per
per time
time period
period xx nono ofof periods
periods
e.g.
e.g. The
The interest
interest rate
rate 1.5%
1.5% per per month
month is is the
the same
same as
as
each
each of of the
the following
following nominal
nominal ratesrates
Time
Time Period
Period NominalNominal rate
rate What What this
this is is
24
24 months
months 1.5x24=
1.5x24= 36%36% Nominal
Nominal rate/2years
rate/2years
12
12 months
months 1.5x12=18%
1.5x12=18% Nominal Nominal rate/1year
rate/1year
66 months
months 1.5X6
1.5X6 == 9% 9% Nominal
Nominal rate/6months
rate/6months
33 months
months 1.5x3
1.5x3 =4.5%
=4.5% NominalNominal rate/3months
rate/3months
Take note:
 Effective
Effective interest
interest rate
rate ii is
is aa rate
rate wherein
wherein thethe
compounding
compounding of of interest
interest is is taken
taken into
into account.
account.
 ii == (1
(1 ++ r/M)
r/M)MM -- 11
 most
most common
common form form ofof interest
interest rate
rate statement
statement when when
compounding
compounding over over time
time period
period shorter
shorter than
than 11 year:
year:
“%
“% per
per time
time period,
period, compounded
compounded ---ly”; ---ly”; e.g.
e.g. 10%
10% per
per
year,
year, compounded
compounded monthly monthly :: rr == 10%10%
ii == (1
(1 ++ 0.10/12)
0.10/12)12 12 –– 11 == 10.47%
10.47% per per year
year
 when
when compounding
compounding period(CP)period(CP) is is not
not given,
given, then
then itit is
is
the
the same
same as as time
time period
period mentioned
mentioned with with the
the interest
interest
rate;
rate; e.g.
e.g. 1.5%1.5% perper month.
month. That That means
means CP CP isis also
also 11
month.
month.
 APR; APY

Annual
Annual Percentage
Percentage Rate(APR);
Rate(APR); often often stated
stated as
as the
the annual
annual
interest
interest rate
rate for
for credit
credit cards,
cards, loans,
loans, and
and house
house mortgages
mortgages
 Same
Same as as nominal
nominal rate,
rate, e.g.,
e.g., an
an APR
APR of of 15%
15% is
is the
the same
same
as
as aa nominal
nominal 15%15% perper year
year
Annual
Annual Percentage
Percentage Yield(APY):
Yield(APY): commonly
commonly statedstated annual
annual
rate
rate of
of return
return for
for investments,
investments, certificates
certificates of
of deposits,
deposits, and
and
saving
saving accounts.
accounts.
 Same
Same as as effective
effective rate
rate
 APY
APY ≥≥ APR,
APR, then
then ii ≥≥ rr
Effective rate per compounding period

•• Effective
Effective raterate per
per CP
CP == (r%
(r% per
per time
time period
period tt )/(M
)/(M
compounding
compounding periodsperiods perper t)
t)
== r/M
r/M
e.g.,
e.g., rr == 9%
9% per
per year
year compounded
compounded monthlymonthly
MM == 12;
12; effective
effective rate
rate per
per month
month == .09/12
.09/12
== 0.75%
0.75% perper month
month
compounded
compounded monthly
monthly
i = (1+0.09/12)12 – 1 = 9.38% per year
COMPOUNDING MORE OFTEN THAN ONCE A
YEAR
Single
Single Amounts
Amounts
•• Given
Given nominal
nominal interest
interest rate rate andand total
total number
number of of
compounding
compounding periods,
periods, P, P, FF oror A A can
can be
be determined
determined by by
F
F == P
P (( FF // P,
P, i%,
i%, N N ))
effective
effective annual
annual interest
interest rate,rate, i%i%
i%
i% == (( 11 ++ rr // M
M )) MM -- 11
Uniform
Uniform and and // oror Gradient
Gradient Series
Series
•• Given
Given nominal
nominal interest
interest rate,rate, total
total number
number of of
compounding
compounding periods,
periods, and and existence
existence of of aa cash
cash flow
flow at
at
the
the end
end of
of each
each period,
period, P, P, F F or
or A A may
may bebe determined
determined
by
by the
the formulas
formulas and and tables
tables for for uniform
uniform annual
annual series
series
and
and uniform
uniform gradient
gradient series.
series.
 Ex.3.12
Ex.3.12 (Sullivan
(Sullivan etet al)
al) Suppose
Suppose that that aa $100
$100
lump
lump sum sum amount
amount is is invested
invested for for 10years
10years at at aa
nominal
nominal interest
interest rate
rate of of 6%
6% compounded
compounded
quarterly.
quarterly. HowHow much
much isis itit worth
worth atat the
the end
end of
of the
the
10
10thth year?
year?
Solution
Solution 1:1: M
M == 4;
4; no
no of
of interest
interest periods
periods == 4(10)4(10) == 40
40
interest
interest rate/interest
rate/interest period
period == 6%/4=1.5%
6%/4=1.5%
FF == P(F/P,
P(F/P, 1.5%,40)
1.5%,40) == 100(1.015)
100(1.015)40 40 =
= $181.40
$181.40
Solution
Solution 2:2: effective
effective interest
interest rate,
rate, ii == (1+0.015)
(1+0.015)44 –– 11
== 6.14%
6.14%
FF == P(F/P,6.14%,10)
P(F/P,6.14%,10) == 100(1.0614)
100(1.0614)10 10 =
= $181.40
$181.40
CONTINUOUS COMPOUNDING
AND DISCRETE CASH FLOWS
• Continuous compounding assumes cash
flows occur at discrete intervals, but
compounding is continuous throughout
the interval.
• Continuous compounding is present
when the duration of compounding
period becomes infinitely small and the
number of times interest is compounded
per period becomes infinite
 CONTINUOUS
CONTINUOUS COMPOUNDING
COMPOUNDING AND
AND DISCRETE
DISCRETE
CASH
CASH FLOWS
FLOWS

•• Given
Given nominal
nominal per per year
year interest
interest raterate -- -- r,r, compounding
compounding
per
per year
year -- -- MM Consider:
Consider: [[ 11 ++ (r (r // M
M )) ]] MM
•• Let
Let MM // rr == p,
p, [[ 11 ++ (r
(r // M
M )) ]] MM == [1
[1 ++ (1/p)
(1/p) ]] rprp
•• But
But lim
lim [[ 11 ++ (1
(1 // p)
p) ]] pp == ee11 == 2.71828
2.71828

•• Thus,
Thus, effective
effective
p continuous
continuous interest
interest rate
rate is:
is: ii == ee rr –– 11
where
where ii and and rr have
have the
the same
same time
time periods
periods
e.g.
e.g. ifif rr == 15%
15% per per year
year compounded
compounded continuously,
continuously, then then
the
the effective
effective continuous
continuous interest
interest per
per year
year is
is
ii == ee0.15
0.15 –
– 1=
1= 16.183%
16.183%
 CONTINUOUS COMPOUNDING AND
DISCRETE CASH FLOWS
Single Cash Flow
• Finding F given P
• Finding future equivalent value given present
value
• F = P (e rNrN)

• Functionally expressed as ( F / P, r%, N )

• e rN
rN is continuous compounding compound

amount
• Predetermined
Predetermined values are in column 2 of appendix
D of text
Professors
Professors Covid
Covid and
and Sars
Sars both
both invest
invest P50,000
P50,000
for
for 10
10 years
years at
at 10%
10% per
per year.
year. Compute
Compute thethe
future
future worth
worth for
for both
both individuals
individuals ifif Covid
Covid
receives
receives annual
annual compounding
compounding and and Sars
Sars
receives
receives continuous
continuous compounding
compounding
•• Covid:
Covid: FF == P(F/P,
P(F/P, 10%,10)
10%,10) == P129,685
P129,685
•• Sars:
Sars: effective
effective ii == ee0.1
0.1 –
– 11 == 10.517%
10.517%
FF == 50000(1+0.10517)
50000(1+0.10517)10 10 =
= P135,913
P135,913 Or,
Or,
FF =50000(F/P,r=10%,
=50000(F/P,r=10%, 10) 10)
== P135,913
P135,913
Note:
Note: Continuous
Continuous compounding
compounding causescauses aa P6228
P6228 increase
increase in in
earnings.
earnings. Try
Try to
to get
get FF when
when compounding
compounding daily
daily is
is applied
applied and
and
compare
compare the
the results
results with
with that
that from
from continuous
continuous compounding.
compounding.
 CONTINUOUS
CONTINUOUS COMPOUNDING
COMPOUNDING AND AND DISCRETE
DISCRETE
CASH
CASH FLOWS
FLOWS
Single
Single Cash
Cash Flow
Flow
•• Finding
Finding P P given
given F
F
•• Finding
Finding present
present equivalent
equivalent value
value given
given future
future value
value
•• PP == F F (e -rN))
(e -rN
•• Functionally
Functionally expressed
expressed as
as (( P
P // F,
F, r%,
r%, N
N ))
•• ee -rN
-rN is
is continuous
continuous compounding
compounding present
present equivalent
equivalent
•• Predetermined
Predetermined values values are
are in
in column
column 33 of
of appendix
appendix
DD ofof text
text
 CONTINUOUS COMPOUNDING AND
DISCRETE CASH FLOWS
Uniform Series
• Finding F given A
• Finding future equivalent value given a series
of uniform equal receipts
• F = A (e rNrN- 1)/(e rr- 1)

• Functionally expressed as ( F / A, r%, N )

• (e rN
rN- 1)/(e rr- 1) is continuous compounding

compound amount
• Predetermined values are in column 4 of
appendix D of text
 CONTINUOUS COMPOUNDING AND
DISCRETE CASH FLOWS
Uniform Series
• Finding P given A
• Finding present equivalent value given a series
of uniform equal receipts
• P = A (e rN rN- 1) / (e rNrN ) (e rr- 1)

• Functionally expressed as ( P / A, r%, N )

• (e rN
rN- 1) / (e rN
rN ) (e rr- 1) is continuous

compounding present equivalent

• Predetermined values are in column 5 of
appendix D of text
 CONTINUOUS COMPOUNDING AND
DISCRETE CASH FLOWS
Uniform Series
• Finding A given F
• Finding a uniform series given a future value
• A = F (e rr- 1) / (e rN rN - 1)

• Functionally expressed as ( A / F, r%, N )

• (e rr- 1) / (e rN
rN - 1) is continuous compounding

sinking fund
• Predetermined values are in column 6 of
appendix D of text
 CONTINUOUS COMPOUNDING AND
DISCRETE CASH FLOWS
Uniform Series
• Finding A given P
• Finding a series of uniform equal receipts given
present equivalent value
• A = P [e rN rN (e rr- 1) / (e rN
rN - 1) ]

• Functionally expressed as ( A / P, r%, N )

• [e rN
rN (e
(e rr- 1) / (e rNrN - 1) ] is continuous

compounding capital recovery

• Predetermined values are in column 7 of
appendix D of text
When N is unknown:
•• E.g.
E.g. P=P= 1000
1000 A A == 200
200 i=12%
i=12% N=?N=?
•• P
P == A(P/A,12%,N)
A(P/A,12%,N)
•• 1000
1000 == 200(P/A,12%,N)
200(P/A,12%,N)
•• 55 == (P/A,12%,N)
(P/A,12%,N)
•• From
From the the table:
table: 88 4.9676
4.9676
•• N
N 55
•• 99 5.3282
5.3282
•• By
By interpolation
interpolation N N == 8.09
8.09 or
or simply
simply get
get the
the reading
reading
nearer
nearer 55
••
When i is unknown:

E.g. P =1000 A = 200 N = 10 years i =?

1000 = 200(P/A, i%,10)
5 = (P/A, i%, 10)
From the table: 5.0188 i = 15%
5 i
4.4941 i = 18%
By interpolation: i = 15.11%
4-74/200

What value of T makes these two cash

flow diagrams economically equivalent at
8% annual interest?
4-79/201

What is the value of K on the left-hand

cash-flow diagram that is equivalent to
the right-hand cash flow diagram? Let i
= 12% per year
4-103/204
4-103/204
You repay a student loan of $20,000 in
equal monthly instalments over 5 years
at a nominal interest rate of 24%,
compounded on a monthly basis. The
interest rate remains constant over this
entire period of time. What is the
monthly repayment amount?
Suppose that you have money market
certificate earning an annual rate of interest,
which varies over time as follows:

If you have invested $10,000 in this certificate at

the beginning of year one and do not add or
withdraw any money for 5 years, what is the value
of the certificate at the end of the fifth year?
4-116/205
4-116/205
Find Z such that the equivalent cash
outflow equals the equivalent cash inflows
when r = 20% compounded continuously?