Theme 4 Effective Interest Rate

Newnan Chpt 4 pp. 106-112

4.1 Definitions
4.1.1 Nominal interest Rate

Nominal interest, r, is an interest rate that does not include any

consideration of compounding.

A nominal interest, r, may be stated for any time period (1 year, 1 month)

% Per time period t

= 12% per year

= 1.5% per month x 24 months
= 36% per 2 year period

None of these nominal rates make mention of the compounding frequency

4.1.2 Effective Interest Rate

Effective interest rate is the actual rate that applies for a stated period of
time. The compounding of interest during the time period of the
corresponding nominal rate is accounted for by the effective interest rate.

Nominal interest rates with different compounding frequencies can not be

compared directly but only by way of the effective interest rate.

An effective interest rate has the compounding frequency attached to the

nominal rate statement

r % per time period , frequency of compounding

12% per year compounded monthly

The time of the cash flow must always coincide with the compounding of
the interest rate.

Options when calculating effective interest rate:

• Change the cash flow.

• Change the interest rate.

Copyright 2012 40
 Effective Interest Rate

i = 12% compounded semi-annually

Calculation of Effective Interest Rate

Compounding frequency of interest is less than the frequency of the

cash flow.
i = 12% Compounded annually

0 S/A1 S/A2 S/A3 S/A4

1000 1000 1000 1000

Bring cash flow in line with compounding of interest

0 S/A1 S/A2 S/A3 S/A4

2000 2000

NPV = 2000(P/A , 12 ,2 )

Copyright 2012 41
 Compounding frequency of interest and the frequency of the cash flow
is the same.
i = 12% Compounded semi-annually

Step 1:
Bring nominal interest rate in line with cash flow (6% semi-
annually).
Compounding of the interest and the cash flow is now at the
same frequency.

0 S/A1 S/A2 S/A3 S/A4

1000 1000 1000 1000

NPV = 1000(P/A , 6 , 4)

Compounding frequency of interest is larger than the frequency of the

cash flow.
i = 12% Compounded quarterly

Step 1:
Bring nominal interest rate in line with cash flow (6% semi-
annually).

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8
0 S/A1 S/A2 S/A3 S/A4

1000 1000 1000 1000

Method 1: Calculate effective interest rate

NPV = 1000(P/A , 6.09 , 4)

Method 2:

i = 12% Compounded quarterly

Step 1:
Bring nominal interest rate in line with cash flow (6% semi-
annually).

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8
0 S/A1 S/A2 S/A3 S/A4

1000 1000 1000 1000

Copyright 2012 42
 Calculate cash flow on a quarterly basis

0 Q1 Q2

A A

F=1000

A = 1000(A/F,3,2)

= 1000(0.4926)

= 492.6 per quarter

NPV = 492.6(P/A,3,8) = 492.6(7.02) = 3458

4.1.3 Formula for Effective Interest Rate

ia = Effective interest rate

r = Nominal interest rate
m= Frequency of compounding of interest per period
l = Number of compounding periods in period required for the effective
interest rate

4.1.4 Continuous Compounding of Interest

The effective annual interest for continuous compounding is derived from:

Assume: l = 1

But since:

and:

Copyright 2012 43
 Then:

An effective annual interest rate of 12% is desired:

a. What nominal rate should be sought if compounding is to be semi-
annually?
b. What nominal rate should be sought if compounding is to be quarterly?
a.

b.

What effective annual interest rate corresponds to the following:

a. Nominal interest rate of 12% compounded semi-annually.
b. Nominal interest rate of 12% compounded monthly.
a.

b.

Find the nominal interest rate per compounding period if the effective
annual interest rate is 12.36% compounded semi-annually:

Y1 Y2 Y3
SA1 SA2 SA3 SA4 SA5 SA6

1000

a. 12% Nominal compounded annually

0 Y1 Y2 Y3

2000 2000 2000

Copyright 2012 44
 P=2000(P/A,12,3)=2000(2.4018)=4803.60

b. 12% Nominal compounded semi-annually

i = r/m = 0.12/2 = 0.06 = 0.6%

P=1000(P/A,6,6)=1000(4.9173)=4917.30

c. 12% Nominal compounded quarterly

Method 1: Calculate Effective Interest Rate

ia= (1 + r/m)l.m -1 = (1 = 0.06/2)1.2 – 1 = 0.0609

P =1000(P/A , 6.09 , 6) = 4902

Method 2: Change Cash Flow

0 Q1 Q2

A A

F = 1000

Interest per quarter =12/4 =3%

A = F(A/F ,i ,n) = 1000(A/F, 3, 2) = 492.6

0 Q1 Q12

492.6

P = 492.6(P/A,3,12) = 4903

0 Y1 Y2 Y3

1000
4.1 Interest rate 12% Nominal

Method 1: Calculate Effective Interest Rate

Copyright 2012 45
 Method 2: Change Cash Flow

A(Y) =1000(A/F,12,3) = 296.4

0 Y1 Y2 Y3

296.4

P = 296.4(P/A,12,3) = 711.89

4.2. 12% Nominal compounded semi-annually

Method 1a

Method 1b

Method 2

A(SA) = 1000(A/F,6,6) = 143.4

0 SA1 SA6

143.4

P = 143.4(P/A,6,6) = 705.14

4.3. 12% Nominal compounded quarterly

Method 1a

Copyright 2012 46
 Method 1b

Method 2

A(Q) = 1000(A/F,3,12) = 70.5

0 Q1 Q12

70.5

P = 70.5(P/A,3,12) = 701.75

Continuous Compounding
One has a loan of R1000 and desires to determine what equivalent
uniform end-of-year payments (A) could be obtained from it for 10 years if
the nominal interest rate is 20% compounded continuously.

Method 1

Method 2

Copyright 2012 47