Equivalence Analysis using

Effective Interest Rates

Sean Piseth

Contemporary Engineering Economics, 4 th

edition, © 2007
Equivalence Calculations using Effective
Interest Rates
 Step 1: Identify the payment period (e.g.,
annual, quarter, month, week, etc)

 Step 2: Identify the interest period (e.g.,

annually, quarterly, monthly, etc)

 Step 3: Find the effective interest rate that

covers the payment period.

Contemporary Engineering Economics, 4 th

edition, © 2007
 Case I: When Payment Period is Equal to
Compounding Period
Step 1: Identify the number of compounding
periods (M) per year

Step 2: Compute the effective interest rate per

payment period (i)
i = r/M

Step 3: Determine the total number of payment

periods (N)
N = M ×(number of
years) Contemporary Engineering Economics, 4
th

edition, © 2007
Example 4.4: Calculating Auto Loan
Payments
Given:
MSRP = $20,870
Discounts & Rebates = $2,443
Net sale price = $18,427
Down payment = $3,427
Dealer’s interest rate = 6.25% APR
Length of financing = 72 months

Find: the monthly payment (A)

Contemporary Engineering Economics, 4 th
edition, © 2007
Solution:

Step 1: M = 12
Step 2: i = r/M = 6.25%/12 = 0.5208% per month
Step 3: N = (12)(6) = 72 months
Step 4: A = $15,000(A/P, 0.5208%,72) = $250.37
Contemporary Engineering Economics, 4 th
edition, © 2007
Dollars Up in Smoke
What three levels of smokers who bought
cigarettes every day for 30 years at $4.75 a
pack would have if they had instead banked
that money each week:
Level of smoker Would have had
1 pack a day $132,110

2 packs a day $264,220

3 packs a day $396,331

Note: Assumes constant price per pack, the money banked weekly and an
annual interest rate of 5.5%

Contemporary Engineering Economics, 4 th

edition, © 2007
Sample Calculation: One Pack per Day
Step 1: Determine the effective interest rate per
payment period.

Payment period = weekly

“5.5% interest compounded weekly”
i = 5.5%/52 = 0.10577% per week

Step 2: Compute the equivalent value at 30 years from now.

Weekly deposit amount

A = $4.75 x 7 = $33.25 per week
Total number of deposit periods
N = (52 weeks/yr.)(30 years)
= 1,560 weeks
F = $33.25 (F/A, 0.10577%, 1560)
= $132,110
Contemporary Engineering Economics, 4 th
edition, © 2007
Practice Problem
 Suppose you drink a cup of Starbuck coffee ($3.00
a cup) on the way to work every morning for 30
years. If you put the money in the bank for the same
period, how much would you have, assuming your
accounts earns a 5% interest compounded daily.

 NOTE: Assume you drink a cup of coffee every day

including weekends.

Contemporary Engineering Economics, 4 th

edition, © 2007
Solution
 Payment period: Daily
 Compounding period: Daily

5%
i  0.0137% per day
365
N  30  365  10, 950 days
F  $3( F / A, 0.0137%,10950)
 $76, 246

Contemporary Engineering Economics, 4 th

edition, © 2007
Case II: When Payment Periods Differ from Compounding
Periods
Step 1: Identify the following parameters
M = No. of compounding periods
K = No. of payment periods
C = No. of interest periods per payment period
Step 2: Compute the effective interest rate per payment
period
For discrete compounding
i  [1  r / CK ]  1 C

For continuous compounding

i  er / K 1
Step 3: Find the total no. of payment periods
N = K (no. of years)
Step 4: Use i and N in the appropriate equivalence formula
Contemporary Engineering Economics, 4 th
edition, © 2007
Discrete Case: Quarterly deposits with Monthly
compounding

Year 1 Year 2 Year 3

F=?
0 1 2 3 4 5 6 7 8 9 10 11 12
Quarters
A = $1,000
 Step 1: M = 12 compounding periods/year
K = 4 payment periods/year
C = 3 interest periods per quarter
 Step 2: i  [1  0.12 /(3)(4)]3  1
 3.030%
 Step 3: N = 4(3) = 12
 Step 4: F = $1,000 (F/A, 3.030%, 12)
= $14,216.24
Contemporary Engineering Economics, 4 th
edition, © 2007
Continuous Case: Quarterly deposits with Continuous
compounding

Year 1 Year 2 Year 3

F=?
0 1 2 3 4 5 6 7 8 9 10 11 12
Quarters
A = $1,000
 Step 1: K = 4 payment periods/year
C =  interest periods per quarter
 Step 2:
ie0 .12 / 4
1
 3.045% per quarter
 Step 3: N = 4(3) = 12
 Step 4: F = $1,000 (F/A, 3.045%, 12)
= $14,228.37
Contemporary Engineering Economics, 4 th
edition, © 2007
Practice Problem

 A series of equal quarterly payments of

$5,000 for 10 years is equivalent to what
present amount at an interest rate of 9%
compounded
 (a) quarterly
 (b) monthly
 (c) continuously

Contemporary Engineering Economics, 4 th

edition, © 2007
Solution

A = $5,000

1 2 40 Quarters

Contemporary Engineering Economics, 4 th

edition, © 2007
 (a) Quarterly
 Payment period :
A = $5,000
Quarterly
 Interest Period:
0
Quarterly
1 2 40 Quarters
9%
i  2.25% per quarter
4
N  40 quarters
P  $5, 000( P / A, 2.25%, 40)
 $130,968

Contemporary Engineering Economics, 4 th

edition, © 2007
 (b) Monthly
 Payment period :
A = $5,000
Quarterly
 Interest Period: Monthly
0

1 2 40 Quarters
9%
i  0.75% per month
12
i p  (1  0.0075)3  2.267% per quarter
N  40 quarters
P  $5, 000( P / A, 2.267%, 40)
 $130,586

Contemporary Engineering Economics, 4 th

edition, © 2007
 (c) Continuously
 Payment period :
A = $5,000
Quarterly
 Interest Period:
0
Continuously
1 2 40 Quarters

i  e0.09 / 4  1  2.276% per quarter

N  40 quarters
P  $5, 000( P / A, 2.276%, 40)
 $130,384

Contemporary Engineering Economics, 4 th

edition, © 2007
A Decision Flow Chart on How to Compute the
Effective Interest Rate per Payment Period

Contemporary Engineering Economics, 4 th

edition, © 2007
Equivalence Calculations
with Continuous Payments

Lecture No.12
Chapter 4
Contemporary Engineering Economics
Copyright © 2006

Contemporry Engineering Economics, 4 th

edition, © 2007
Single-Payment Transactions with
Continuous Compounding – Future Worth

F  P(1  i ) N

 P(1  e r  1) N 0
N
 Pe rN

Contemporary Engineering Economics, 4 th

edition, © 2007
Practice Problem
 If you invest $1,000 in a
savings account that ia  e  1 0.06

pays 6% annual  6.18%

interest compounded
continuously, what F  $1,000( F / P,6.18%,3)
would be the balance at
the end of 3 years?  $1,197.09

Contemporary Engineering Economics, 4 th

edition, © 2007
Single-Payment Transactions with Continuous Compounding –
Present Worth

N
P  F (1  i )
N 0
 F (1  e  1)
r
N
 rN
 Fe
P

Contemporary Engineering Economics, 4 th

edition, © 2007
Continuous-Funds Flow

P   f (t )t e
t 0
 rt

N
  f (t )e  rt dt
0

Contemporary Engineering Economics, 4 th

edition, © 2007
Summary of Interest Factors for Typical Continuous
Cash Flows with Continuous Compounding

Contemporary Engineering Economics, 4 th

edition, © 2007
Example 4.9 Comparison of Daily Flows and Daily
Compounding with Continuous Flows and Continuous
Compounding

Contemporary Engineering Economics, 4 th

edition, © 2007
Solution:
 Daily Transaction:
F  $200( F / A, 0.01644%, 455)
 $200(472.4095)
 $94, 482
The difference
 Continuous Flow: between
f (t )  A, 0  t  1.25
the two methods
 $200(365)
 $73, 000 is only $277.
1.25
F  
0
73, 000e 0.06 (1.25 t ) dt

 e 0.075  1 
 $73, 000  
 0.06 
 $94, 759
Contemporary Engineering Economics, 4 th
edition, © 2007