CVE 267: Civil Engineering Cost Analysis

Outline
4. Nominal and Effective
Interest Rates
4.1 Introduction
4.2 Nominal and Effective Interest Rates
4.3 Effective Annual Interest Rates
4.4 Equivalence Relations for PP ≥ CP
4.5 Equivalence Relations for PP < CP
Dr. Sami W. Tabsh, P.E.
Civil Engineering 4.6 Continuous Compounding
AUS

Reference: Engineering Economy, Blank & Tarquin, McGraw-Hill 1 2

4.1 Introduction 4.1 Introduction

In the interest equations
developed thus far, the The difference between simple interest
rate has been a constant, and compound interest is that the later
annual value. includes interest on interest earned in
previous periods, while the former
For many projects, the interest rate is
doesn’t.
compounded more frequently than once a
year (e.g. monthly or quarterly). Nominal and effective interest rates
have essentially the same basic
This requires the introduction of 2 new
relationship.
terms: nominal and effective interest
rates. 3 4
4.2 Nominal and Effective 4.2 Nominal and Effective
Interest Rates Interest Rates
Nominal interest rate, r, is an interest For example, the nominal rate r = 2% per
rate that does not include any month is the same as:
consideration of compounding, that is: r = (2%)(12 months) = 24% per year,
r = (interest rate/period) (# of periods) r = (2%)(3 months) = 6% per quarter,
----------- (4.1) r = (2%)(0.231 month) = 0.462% per week
If a nominal interest rate r is stated for any Note that none of these nominal rates
period (1 year, quarterly, daily, etc.), Eq. mention the compounding frequency.
4.1 can be used to find the equivalent r They have the format “r% per time period.”
for any period. 5 6

4.2 Nominal and Effective 4.2 Nominal and Effective

Interest Rates Interest Rates
Now, consider an effective interest rate:
All of the interest formulas, tabulated
Effective interest rate is the actual rate
values and spread sheet relations must
that applies for a stated period of time.
have the effective interest rate to properly
The compounding of interest during the
account for the time value of money.
time period of the corresponding nominal
rate is accounted for by the effective Sometimes the Annual Percentage Rate
interest rate. (APR) and Annual Percentage Yield
(APY) are used instead of the nominal
It is commonly expressed on an annual
and effective interest rates.
basis as the “effective annual rate ia”. 7 8
 4.2 Nominal and Effective 4.2 Nominal and Effective
Interest Rates Interest Rates
Based on the above, there are 2 time The “compounding frequency” is the
units associated with interest: number of times (m) that the compounding
i- Interest Period: occurs within the time period t.
The basic time unit of the interest rate. It is For example, 10% interest per year,
the t in the statement “r% per time period t.” compounded quarterly, has a
ii- Compounding Period (CP): compounding frequency of m = # of
The time unit used to find the effect of the quarters/year = 4. Similarly, 2% interest
interest. It is defined by the compounding per quarter, compounded monthly means
term in the interest rate statement. 9 m = # of months/quarter = 3. 10

4.2 Nominal and Effective 4.2 Nominal and Effective

Interest Rates Interest Rates
In previous chapters, all interest rates had For example, if r = 18% per year,
t and m values of 1 year. This means that compounded monthly; then:
the rates previously considered were both
m = # of months/year = 12 and Eq. 4.2 is
the nominal and effective rates.
used to get the effective rate per month:
The corresponding effective rate per CP is:
r% per time period t 18%
Effective rate/CP = Effective interest rate = = 1.5% per month
No. of compounding periods/t 12
r
or Effective rate/CP = ----------(4.2)11
m 12
 4.2 Nominal and Effective 4.2 Nominal and Effective
Interest Rates Interest Rates
The various ways for reporting interest are: Example 4.1:
Statement Examples Effective Rate A person deposited 5,000
Nominal rate and 10% per year, Find effective rate dirhams into a bank account
compounding period compounded monthly
stated that pays 8% interest rate
Use effective rate
per year, compounded
Effective rate stated Effective 10.47% per
year, compounded directly semi-annually. How much
monthly
money would be in the 2of Serials
Rate is effective Gnorthe
Interest rate stated,
no compounding
10% per year, or
10/12 = 0.833% per only for stated time savings account after one

·
period month 13 year? 14

4.2 Nominal and Effective 4.2 Nominal and Effective

Interest Rates Interest Rates P'(( +i) S100
5000(1 + 4% ) = dirkes
Solution:
Thus, the initial amount of 5,000 dirhams
The cash flow diagram for the problem is:
would become after 6 months:
?
0
P’(1 + i) = 5,000(1 + 0.04) = 5,200 dirhams
2 # of semi-annuals Further, at the end of the 2nd six-month
1
period, the amount in the account
5,000 becomes:
8% interest per year, compounded semi- [P’(1 + i)]x(1 + i) = 5,200(1 + 0.04)
annually, means that the bank pays r/m = = 5,408 dirhams
4% effective interest every 6 months. 15 p'CIti) x CHi) 16

S200x (10 04/ .

 = S408 dirkens

4.3 Effective Annual Interest Rates 4.3 Effective Annual Interest Rates
To find the future worth F at the end of the
Here the year is used as the time period t,
and the compounding period (CP) can be
first year for a principal P at an interest
any time unit less than 1 year. rate i per compounded period, we use:
Let r = nominal interest rate per year, F = P (1 + i)m --------------- (a)
P(1+i)m-1
m = # of compounding periods per year, P(1+i)2 P(1+i)m-2 F=P(1+i)m
P(1+i)
i = effective interest rate per 0
compounding period (CP) = r/m, 1 year
P
ia = effective interest rate per year. i i i i i Effective i/CP
17 18
1 2 3 m-1 m CP

4.3 Effective Annual Interest Rates 4.3 Effective Annual Interest Rates
Tables of effective annual interest rates
Alternatively, if we use the effective
can be generated using Eq. 4.3 for nominal
annual interest rate, ia, then F can be
rates compounded over different times.
found from:
For example, for r = 12% per year:
F = P (1 + ia) --------------- (b) Effective Annual

Equating the right side of Eqs. a and b, CP = 1 Year r/m=12% ia = 12.00%

and canceling P out, we get: CP = 6 Months 6% 6% ia = 12.36%
ia = (1 + i)m - 1 --------------- (4.3) CP = Quarter 3% 3% 3% 3% ia = 12.55%
where i = effective interest rate/CP = r/m CP = 1 Month 1% 5%
1% 1% 5%
1% 1% 1% 1% 5%
1% 1% 5%
1% 1% 1% ia = 12.68%
19 Distribution of i over the year 20
 4.3 Effective Annual Interest Rates
Nominal
Rate r%
Semiannually Quarterly Monthly
(m = 2) (m = 4) (m = 12)
Weekly
(m = 52)
Daily
(m = 365)
4.3 Effective Annual Interest Rates
0.25 0.250 0.250 0.250 0.250 0.250
0.50 0.501 0.501 0.501 0.501 0.501 Note that Eq. 4.3 can be written as:
1 1.002 1.004 1.005 1.005 1.005
2 2.010 2.015 2.018 2.020 2.020 ieff = (1 + r/m)m - 1
3 3.022 3.034 3.042 3.045 3.045
4 4.040 4.060 4.074 4.079 4.081
5 5.062 5.095 5.116 5.125 5.127
in which ieff and r have the same time unit.
6
7
6.090
7.122
6.136
7.186
6.168
7.229
6.180
7.246
6.183
7.250
For example, if the interest is 18% per year
8 8.160 8.243 8.300 8.322 8.328 compounded monthly, one can find the
9 9.202 9.308 9.381 9.409 9.416
10 10.250 10.381 10.471 10.506 10.516
effective interest rate per quarter:
12
15
12.360
15.563
12.551
15.865
12.683
16.075
12.734
16.158
12.747
16.180
First, find r = 18% ÷ 4 = 4.5% per quarter
20 21.000 21.551 21.939 22.093 22.134 Next, m = # of months per quarter = 3
30 32.250 33.547 34.489 34.870 34.969 21
50 56.250 60.181 63.209 64.479 64.816 Last, ieff = (1 + 0.045/3)3 – 1 = 4.568% 22

4.3 Effective Annual Interest Rates 4.3 Effective Annual Interest Rates
$1,000 t = Years
$1,000
1 2 3 4 ieff=(1+0.18/12)12-1 1 2 3 4
0 t (years) t (years)
=19.56% per year 0
18% per year,
F=?
compounded monthly F=? F = 1,000(F/P,19.56%,4) = $2,043
The above problem can be solved in t = Months $1,000
different ways, for example: r=18%÷12=1.5% per month, 12 24 36 48
t (months)
– Keep time in years: compounded monthly 0

– Change time to months => ieff=(1+0.015/1)1-1

F=?
=1.5% per month
– Change time to quarters
– Change time to biennium (2-years)
23
F = 1,000(F/P,1.5%,48) = $2,043 24
4.3 Effective Annual Interest Rates 4.3 Effective Annual Interest Rates
t = Quarters $1,000
r=18%÷4=4.5% per quarter 4 8 12 16
t (quarters)
Example 4.2:
compounded monthly 0
ieff=(1+0.045/3) -1=4.568% per quarter
3 On January 1st, Ali borrowed $1,000 from
F=? the bank. The loan is to be repaid by four
F = 1,000(F/P,4.568%,16) = $2,043 equal payments which are due at the end
of March, June, September, and
t = Biennium $1,000
December. If the bank charges 18% per
r=18%x2=36% per biennium 1 2
year nominal interest, compounded
t (biennium)
compounded monthly 0
quarterly, what is the amount of each
ieff=(1+0.36/24)24-1=42.95% per biennium F=? payment? What is the effective annual
F = 1,000(F/P,42.95%,2) = $2,043 25 interest rate? 26

4.3 Effective Annual Interest Rates 4.3 Effective Annual Interest Rates
Solution: So, the amount of each of the 4 uniform
Payments are to be made every three payments is:
months (i.e. quarterly). Hence, the cash
A = P(A/P,4.5%,4) = 1000(0.2787)
flow diagram (with time in quarters) is:
=> A =$278.7
$1,000
1 2 3 4 # of quarters The effective interest over the year is
0 obtained from Eq. 4.3:
A
The interest is charged quarterly at a rate: ia = (1 + i)m - 1 = (1 + r/m)m - 1
i = r/m = 18%  4 = 4.5% per quarter. 27 = (1 + 0.18/4)4 - 1 = 19.25% per year 28
4.3 Effective Annual Interest Rates 4.3 Effective Annual Interest Rates
Example 4.3: a. What is the amount of George's annual
George bought a new car for $15,000 payment?
and agreed to pay for it as follows: 1/3rd b. After 3 years (just before making his 3rd
down payment; with the balance to be payment), George made enough money
paid in 5 equal annual payments; the that he decided to pay off the entire
first payment due 1 year from the day of balance due on the car. How much
purchase. The annual nominal interest money does George owe at that point?
rate is 9%, compounded monthly.
29 30

4.3 Effective Annual Interest Rates 4.3 Effective Annual Interest Rates
m = number of months per year = 12
Solution:
a. George's car loan after 1/3 down => the effective interest rate per month is:
payment is = 15,000*2/3 = $10,000. i = r/m = 9/12 = 0.75% per month.
This amount has to be paid back in 5 and the effective annual interest rate, ia,
uniform payments at can be obtained from Eq. 4.3.
$10,000 ia = (1 + i)m - 1 = (1 + 0.0075)12 - 1
1 2 3 4 5 # of years = 0.09381 or 9.381% per year.
0 Thus, the annual payments should be:
A 31 32
A = 10,000 (A/P,9.381%,5) = $2,596.
4.3 Effective Annual Interest Rates 4.3 Effective Annual Interest Rates
b. Up to end of the 3rd year, George has So if George wants to pay off the entire
made 2 payments. So, he owes 3 more loan at the end of the 3rd year, then he
payments. Out of these, one payment is has to pay the 3rd-year payment, plus the
due right away, and the remaining 2 equivalent amount of the following 2
payments in the following 2 years. payments.
Thus, the required amount to pay off the
Present
$10,000 loan is:
1 2 3 4 5 # of years
Payoff = 2,596 + 2,596 (P/A,9.381%,2)
0
$2,596 33 = 2,596 + 2,596 (1.75) = $7,140. 34

4.4 Equivalence Relations for PP ≥ CP 4.4 Equivalence Relations for PP ≥ CP

A. Single Amounts with PP ≥ CP:
Sometimes, the frequency of cash flows is
not equal to the frequency of interest When only single amount cash flows are
compounding (e.g. cash flows occur involved, i and n for the P/F and F/P
monthly while interest compounding factors can be found by two methods.
occurs annually). $3,500
To perform equivalence analyses, the 0
compounding period (CP) and payment 1 2 3 4 years
period (PP) must be on the same time $2,000
$3,000
basis, with interest adjusted accordingly.
35 r = 8% per year, compounded semi-annually 36
 4.4 Equivalence Relations for PP ≥ CP
4.4 Equivalence Relations for PP ≥ CP
For example, if the nominal r = 10% per
Method 1: year, compounded quarterly, then CP = 1
Determine the effective interest rate over quarter. To find P or F over a 3-year span,
the compounding period CP, and set n we calculate the effective quarterly rate of i
equal to the number of compounding = 10% ÷ 4 quarters = 2.5%, and the total #
periods between P and F: of quarters in 3 years n = 4x3=12.
P=F(P/F, effective_i%_per_CP, total_#_of_periods_n) F
F=P(F/P, effective_i%_per_CP, total_#_of_periods_n) 0
4 8 12 quarters
----------- (4.4)
P i = 2.5% per quarter
37
In this case, F = P(F/P,2.5%,12) 38

4.4 Equivalence Relations for PP ≥ CP 4.4 Equivalence Relations for PP ≥ CP

Method 2: For example, if the nominal r = 10% per
Here, we determine the effective interest year, compounded quarterly, then m = 4.
rate for the time period t of the nominal To find P or F over a 3-year span, we
rate, and then we set n equal to the total calculate the effective annual rate ia =
number of periods using this time period. (1+0.10/4)4 – 1 = 10.38%, and the number
The term “effective i% per t” is substituted of years n = 3.
for the interest rate in Eqn. 4.4, to get: F
0
P=F(P/F, effective_i%_per_t, total_#_of_periods_n) years
1 2 3
F=P(F/P, effective_i%_per_t, total_#_of_periods_n)
P ia = 10.38% per year
----------- (4.5)
39 40
In this case, F = P(F/P,10.38%,3)
4.4 Equivalence Relations for PP ≥ CP 4.4 Equivalence Relations for PP ≥ CP
Solution:
Example 4.4: The cash flow diagram for the investment
A person plans to invest is shown below. Only P and F are
in a business with a rate involved:
of return of 8% per year, F=?
compounded quarterly. 0 2

How much money he would make 4 years 1 3 4 years

from now, if he invests $2,000 now and $3,000
$2,000
$3,000 after 2 years?
41 r = 8% per year, compounded quarterly 42

4.4 Equivalence Relations for PP ≥ CP 4.4 Equivalence Relations for PP ≥ CP

F=?
0 8
Method 1
4 12 16 quarters
Use the quarterly CP (m=4) to express
$3,000
the effective quarterly interest rate: $2,000
i = 2% per quarter
i = r/m = 8 ÷ 4 = 2%
The total # of quarters is: F = $2,000 (F/P, 2%,16)
n = (2 yrs)(4 quarters/yr) = 8 quarters + $3,000 (F/P, 2%,8)
n = (4 yrs)(4 quarters/yr) = 16 quarters = (2,000)(1.3728) + (3,000)(1.1717)
43 = 2746 + 3515 = $6,261 44
 4.4 Equivalence Relations for PP ≥ CP
4.4 Equivalence Relations for PP ≥ CP
F=?
Method 2 2
0
The effective annual rate based on 4 years
1 3
quarterly compounding:
$2,000 ia = 8.24% per year
Effective ia per year = (1 + r/m)m - 1 $3,000
= (1 + 0.08/4)4 - 1
F = $2,000 (F/P, 8.24%,4)
= 0.0824 or 8.24%
+ $3,000 (F/P, 8.24%,2)
The “n” value is the actual number of
= (2,000)(1.0824)4 + (3,000)(1.0824)2
years.
45 = 2746 + 3515 = $6,261 46

4.4 Equivalence Relations for PP ≥ CP 4.4 Equivalence Relations for PP ≥ CP

B. Series with PP ≥ CP:
When uniform or gradient series are
The procedure in cases of a series (A or
included in the cash flow diagram, Method 2
G) and the payment period equals or
is basically used with PP now defined by
exceeds the compounding period
the frequency of the cash flows, which
requires:
establishes the time unit of the effective
interest rate (otherwise, the uniform series i- Finding the effective i% per payment
and gradient will change to single amount). period, and then
A=$1,750 ii- Determining n as the total number of
quarters payment periods.
0 1 2 3 4 5
47 48
r = 5% per year, compounded monthly
4.4 Equivalence Relations for PP ≥ CP 4.4 Equivalence Relations for PP ≥ CP
Solution:
Example 4.5: The payment period (monthly) is longer than
Hala regularly deposits half of her salary the compounding period (daily), i.e. PP > CP.
each month in a bank account that pays Given: r = 6 ÷ 12 = 0.5% per month and m=30
her 6% per year interest, compounded days, and noting i = r/m. Hence, the effective
daily. How much would she have saved monthly rate based on daily compounding:
in 3 years if her salary is $3,500 per Effective i per month = (1 + r/m)m - 1
month? Assume the salary will not = (1 + 0.005/30)30 - 1
increase with time and the month is = 0.005012 or 0.5012%
approximately equal to 30 days. 49 50

4.4 Equivalence Relations for PP ≥ CP 4.5 Equivalence Relations for PP < CP

A=$1,750
There are two policies on how inter-period
0
12 24
36 months compounding is handled when cash flow
ieff = 0.5012% per month F=? transactions occur between compounding
The total number of monthly payment points: (1) inter-period cash flows earn no
periods in 3 years = 12(3) = 36. Hence, interest, or (2) they earn compound
interest. The first policy is not covered in
F = A (F/A, 0.5012%, 36)
the course.
= ($3,500/2) (1+i) - 1
n $500
i 3 4
(1+0.005012)36 - 1 0 1 2 5 6 months
= ($1,750) = $68,853 $400 $300
0.005012 51
i = 6% per year, compounded quarterly
52
4.5 Equivalence Relations for PP < CP 4.5 Equivalence Relations for PP < CP
$500 inter-period compounding
interest is earned
B. “Inter-period Compounding Interest is 0 3 4
Earned” policy: 1 2 5 6 months
$400 $300
If inter-period compounding interest is i = 6% per year, compounded quarterly
earned, then the cash flows are not moved,
and the equivalent P, F and A values are Here, all cash flows stay where they are.
The time scale is kept in months:
determined using the effective interest rate
per payment period (PP). Here, the r = 6% ÷ 12=0.5% per month, compd’d quart.
effective interest rate formula will have an m = # of quarters/mon. = 0.333
“m” value less than 1, since there is a => ieff = (1 + 0.005/0.333)0.333 - 1 = 0.004975
fraction of the CP within one PP. 53
or i = 0.4975% per month. 54

4.5 Equivalence Relations for PP < CP 4.5 Equivalence Relations for PP < CP
Solution:
Example 4.6:
Jessica is planning to deposit $500 in her The cash flow diagram for the problem is
saving account every two months for a shown below:
Don’t combine!
1,000
period of one year, and expects to make
one withdrawal of $1,000 after 8 months.
How much will she get at the end of the 1 2 3 4 Quarters

year if the interest rate is 8% per year, 0 1 2 3 4 5 6 7 8 9 10 11 12 months

compounded quarterly. Assume inter- 500 500 500 500 500
500
period compounding interest is earned
55 i = 8% per year, compounded quarterly 56
4.5 Equivalence Relations for PP < CP 4.5 Equivalence Relations for PP < CP
1,000
Interperiod compounding is earned:
2 4 6 10 12
 In this case, the the cash flows are not 3 5 7 9 11
0 1 months
moved, and ieff (per month) is computed: 500 500 500 500
500 500
r = 8% per year, compounded quarterly i = 0.662% per month
or r = 8%÷12 = 0.667% per month,
F= -500[(F/P,0.662%,10)+(F/P,0.662%,8)
compounded quarterly
+(F/P,0.662%,6)+(F/P,0.662%,2)]
=> m = # of quarters /month = 1/3 = 0.333
+(1000-500)(F/P,0.662%,4)
ieff = (1+r/m)m – 1=(1+0.00667/0.333)0.333 - 1
-500
= 0.00662 or 0.662% per month.
57
=> F = -$2,075. 58

4.5 Equivalence Relations for PP < CP 4.5 Equivalence Relations for PP < CP
1,000
Note that it is easier to solve the case of
”inter-period compounding is earned” 1 2 3 4 5 6 bi-month
by computing ieff on a bi-monthly basis 0
500 each
since the cash flows occur bi-monthly: i = 1.329% per 2-month
r = 8% per year, compounded quarterly
F= -500(F/A,1.329%,6)
or r = 8% ÷ 6 = 1.333% bi-monthly,
+1,000(F/P,1.329%,2)
compounded quarterly
m = # of quarters / 2-month = 2/3 = 0.667 (1.01329)6 – 1
=> F=-500 + 1000(1.10329)2
ieff=(1+r/m)m-1= (1+0.01333/0.667)0.667 - 1 0.01329
= 0.01329 or 1.329% per 2-month. 59 or F = -$2,075 (same answer as before!)
60
4.6 Continuous Compounding 4.6 Continuous Compounding
If we allow compounding to occur more From Eq. 4.3, let h = m/r =>
often, the compounding period CP
becomes shorter and the number of CP lim i = lim (1+r/m)m - 1 = lim (1+1/h)hr - 1
m m h

8
per payment period (m) increases. Hence,

8
as m approaches infinity, called
= lim [(1+1/h)h]r - 1
continuous compounding, the effective h

8
interest rate must be written in a new form.
Recall from calculus, = er – 1
lim (1 + 1/h)h = e
h 61 => i = er - 1 ------------- (4.6) 62
8

4.6 Continuous Compounding 4.6 Continuous Compounding

Equation 4.6 is used to compute the Example 4.7:
effective continuous interest rate, i, when A bank sells savings certificates that are
the time period on i and r is the same. based on 6% interest rate per year,
For example, if the nominal r is 12% per compounded continuously.
year, compounded continuously, then: a. If the certificate pays the buyer 10,000

Effective continuous rate/year = er – 1 Dirhams after 5 years, what should be the

cost of the certificate?
or i = e0.12 - 1 = 0.1275 or 12.75%.
b. If the bank has another offer that
For r = 1% per month, compounded guarantees doubling ones money, what
continuously => The effective rate per should be the advertised time span to
month = e0.01 - 1 = 0.01005 or 1.005%. 63 double the money? 64
4.6 Continuous Compounding 4.6 Continuous Compounding
Solution: b. Here, F = 2P, i% = 6.18%, and n = ?
a. Effective continuous rate/year = er – 1 => F = P (F/P,i%,n)
or i = e0.06 – 1 = 0.0618 or 6.18%. But F = 2P and (F/P,i%,n) = (1 + i)n
Hence, P = 10,000 (P/F,6.18%,5) Hence, 2 = (1 + 0.0618)n
= 7,409 Dirhams.
and n = (ln2)/[ln(1 + 0.0618)] = 11.56 yrs
10,000
F = 2P
0 0
1 2 3 4 5 years 1 2 3 n-1 n years
P=? ieff = 6.18% per year
65 P ieff = 6.18% per year 66

4.6 Continuous Compounding 4.6 Continuous Compounding

Example 4.8: Solution:
If a nominal interest rate which is a) Effective continuous rate/month = er – 1
compounded continuously leads to an which results in: 0.015 = er – 1
effective monthly interest rate of 1.5%, where r = nominal monthly interest rate
determine:
Solve => r = 0.01489 or 1.489% per month.
a. Nominal annual interest rate that is
b) The equivalent nominal interest rate/year
compounded continuously, and (compounded continuously) is:
b. Effective annual interest rate. => r = 1.489x12 = 0.1787 or 17.87% per yr
Now, effective continuous rate/yr = er – 1
67 => i = e0.1787 – 1 = 0.1956 or 19.56% per yr68