Because learning changes everything.

Slides to accompany
Basics of Engineering Economy
Third edition
by
Leland Blank and Anthony
Tarquin
Chapter 3

Nominal and Effective Interest Rates

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Chapter 3 – Purpose and Topics

TOPICS
• Recognize nominal and effective
rates.
PURPOSE • Effective interest rates.
Perform calculations • Payment period (PP) and
for interest rates and compounding period (CP).
cash flows that occur on • Single amounts with PP ≥ CP.
a time basis other than • Series with PP ≥ CP.
annually • Single and series with PP < CP.
• Spreadsheet use.
• Personal finances.

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 Section 3.1 – Nominal and Effective
Statements

• The concepts of nominal and effective are used

when interest is compounded more than once
each year.
• Every nominal interest rate must be converted
into an effective rate before it can be used in
formulas, factor tables, calculator, or spreadsheet
functions.

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 Section 3.1 – Nominal and Effective
Statements
Nominal rates Effective rates
Interest rate per time period Interest rate is compounded more
without regard to compounding frequently than once per year.
frequency. Some statements indicating an
Some nominal statements: effective rate:
• 8% per year compounded monthly. • 15% per year.
• 2% per month compounded • Effective 8.3% per year compounded
weekly. monthly.
• 8% per year compounded • 2% per month compounded monthly.
quarterly. • Effective 1% per week compounded
• 5% per quarter compounded continuously.
monthly.

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 Section 3.1 – Nominal and Effective
Statements

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 Section 3.1 – Nominal and Effective
Statements

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 Section 3.1 – APR and APY - What
they mean
Annual Percentage Rate (APR) Annual Percentage Yield (APY)
Stated for annual interest rate for Stated as annual rate of return for
borrowers, such as rates on: earners, such as rates on:
• Credit cards. • Investments (stocks, bonds).
• Loans (car and personal). • Savings.
• House mortgages. • Certificates of deposit.

Same as nominal rate. Same as effective rate.

Example: Credit card charges APR Example: Certificate pays APY of
15.5% per year or 1.291% per month. 3.5% per year, which is an APR of
3.445% per year compounded
monthly.

Effective rate ≥ nominal rate and APY ≥ APR

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 Section 3.1 – Guidelines and Rules

Be sure to recognize whether a stated rate is nominal

effective.
If a compounding period is not mentioned, it is the same
as that of the stated rate.
• Very Important: Only effective rates can be used in
all formulas, factor tables, spreadsheet and
calculator functions.

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 Section 3.2 – Nominal Interest Rate
Formula
r = nominal rate over some time period
FORMULA
r = interest rate per period × number of periods

EXAMPLES: interest rate of 1.5% per month

is the same nominal rate as all of the following:
• 4.5% per quarter (numbers of periods = 3).
• 9% per 6-months (numbers of periods = 6).
• 18% per year (numbers of periods = 12).
• 36% per 2 years (numbers of periods = 24).

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 Section 3.2 – Effective Interest Rate
Formula

i per period  (1  r / m) m  1

• i = effective rate per some stated period, for example,

quarterly, annually.
• r = nominal rate for same time period.
• m = number of times interest is compounded per same
time period.

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 Section 3.2 – Different
Compounding Frequencies for i

Compounding Period for Time period m must

frequency effective i for r equal
Annual annual year 1
Semi-annual annual year 2
Quarterly annual year 4
Monthly annual year 12
Daily annual year 365
Monthly semi-annual 6 months 6
Weekly quarterly quarter 13

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 Section 3.2 – Effective Interest Rates -
Example 3.1a

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 Section 3.2 – Effective Interest Rates -
Example 3.1a

i per period  (1  r / m) m  1

Your VISA credit card has APR = 12% per year on unpaid balance.
Find the effective rate per year and semiannually. Payments are made
monthly.
Effective annual rate: r = 12% per year m = 12
i per year  (1  0.12 /12)12  1  0.1268 (12.68%)

Effective semiannual rate: r = 6% per 6 months m=6

i per 6 months  (1  0.06 / 6)6  1  0.0615 (6.15%)

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 Section 3.2 – Effective Interest Rates -
Example 3.1b

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 Section 3.2 – Nominal and Effective
Rates - Another Example
Nominal Effective
r = rate / period × periods i per period  (1  r / m) m  1
Rate is 1.5% per month. Credit card rate is 1.5% per month
Determine nominal rate per compounded monthly. Determine
quarter, year, and over 2 years effective rate per quarter and per year
Qtr: r = 1.5 × 3 mth = 4.5% Period is quarter:
r = 1.5 × 3 mth = 4.5%
Year: r = 1.5 × 12 mth = 18% m=3
= 4.5 × 4 qtr = 18% i  (1  0.045 / 3)3  1  4.57% per qtr

Period is year:
2 Yrs: r = 1.5 × 24 mth = 36%
r = 1.5 × 12 months = 18%
= 18 × 2 yrs = 36%
m = 12
i  (1  0.18 / 12)12  1)  19.6% per year
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 Section 3.2 – Effective Continuous
Interest
As m  , continuous compounding is approached.

effective i  (e r  1)

Example: r = 15% per year compounded

continuously
i  (e 0.15
 1) 100%  16.183% per year

Note: See slides for Section. 3.7 for spreadsheet functions used to display
effective and nominal rates.

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 Section 3.2 – Effective Continuous
Interest- Example 3.2

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 Section 3.2 – Effective Continuous
Interest

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 Section 3.3 – Payment Periods (PP)
and Compounding Periods (CP) 1

PP: how often cash flows occur.

CP: how often interest in compounded.
If PP = CP and these are the same as the interest period, no problem
concerning effective i rate.

Example:
Monthly deposits (PP)
Semiannual compounding (CP)

Examples where effective i is involved:

• Monthly deposit, quarterly compounding (PP < CP; mth < qtr).
• Semi-annual payment, monthly compounding (PP > CP; 6-mth > mth).

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 Section 3.3 – Payment Periods (PP)
and Compounding Periods (CP) 2

Initial things to observe about cash flows

1. Compare length of PP with CP:
PP = CP PP > CP PP < CP
2. Determine types of cash flows present:
• Only single amounts (P and F).
• Series (A, G, g).
3. Determine correct effective i and n (same time unit on both).

Remember: An effective i rate must be used in all

factors and functions
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 Section 3.4 – Equivalence with Single
Amounts 1

If only P and F are present, equivalence relations are:

P = F(P/F, effective i per period, numbers of periods) [1]
F = P(F/P, effective i per period, numbers of periods) [2]

Example: Find equivalent F in 10 years if P = $1000 now. Let r

= 12% per year compounded semiannually.
• PP = year and CP = 6 months; period is 6 months.
• Only single amount cash flows are involved.
• There are 20 semiannual periods in 10 years.
• Use relation [2] to find F.
F = 1000(F/P, 6% semiannually, 20 periods)
= 1000(3.2071) = $3207.10
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 Section 3.4 – Equivalence with Single
Amounts 2

Alternative methods to determine F

Same Example: Find equivalent F in 10 years if P = $1000 now.
Let r = 12% per year compounded semiannually.
• Use effective rate i: r = 12% per year; m = 2; n = 10
i / year  (1  0.12 / 2) 2  1  0.1236
F = 1000(F/P,12.36%,10)
= 1000(3.2071)
= $3207.10
• Use FV spreadsheet function:
= − FV(6%,20,,1000) displays an F of $3207.14
or = − FV(12.36%,10,,1000) displays an F of $3207.14
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 Section 3.4 – Equivalence with Single
Amounts 2

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 Section 3.4 – Equivalence with Single
Amounts – Example 3.3

PP =1 year, CP=6 months, Effective semiannual rate: r = 6% per 6 months

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 Section 3.4 – Equivalence with Single
Amounts – Example 3.3

Alternative solution: find the effective annual rate and express n years

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 Section 3.5 - Equivalence for Series
with PP ≥ CP
CP: Compound Period; PP: Payment Period

Three relationship types of PP and CP:

Type 1. PP=CP
Type 2. PP>CP
Type 3. PP<CP

When PP=CP or PP>CP, the calculation procedure:

Step 1: Count the number of payments and use that number as n. For
example, if payment are made quarterly for 5 years, n = 20.
Step 2. Find the effective interest rate over the same time period used
to calculate n in step 1. For example, if n is expressed in quarters, then
the effective interest rate per quarter must be used.

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 Section 3.5 - Equivalence for Series
with PP ≥ CP

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 Section 3.5 - Equivalence for Series
with PP ≥ CP
• Count number of payments. This is n.
• Determine effective i over same time period as n.
• Use the effective i and n values for equivalence.

Example: $75 per month for 3 years at 12% per year compounded
monthly
PP = CP = month
Time period is month; the PP n value is
n = 36 months
effective i = 12%/12 = 1% per month
Relation using F/A factor: F = 75(F/A,1%,36)
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 Section 3.5 – Series & PP ≥ CP -
Example
• Count number of payments. This is n.
• Determine effective i over same time period as n.
• Use these i and n values in computations.

Example: $5000 per quarter for 6 years at 12% per year compounded monthly.
PP = quarter and CP = month → PP > CP
Time period for i is a quarter, the PP n value is
n = 24 quarters
i = 1% per month or 3% per quarter
m = 3 CP per quarter
effective i per quarter  (1  0.03 / 3)3  1  3.03%

Relation using F/A factor: F = A(F/A,3.03%,24)

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 Section 3.5 – Series with PP ≥ CP -
Example 3.4

• Count number of payments. This is n = 2(7)=14.

• Determine effective i over same time period as n.
r=interest rate per period  number of periods = 10% per year×0.5=5%
𝑟 𝑚 0.05 2
Because PP (6 months) > CP (3 months), 𝑖 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 = 1 + −1= 1+ − 1 = 5.063%
𝑚 2
• Use these i and n values in computations
𝐹 = 𝐴 𝐹ൗ𝐴 , 𝑖, 𝑛 = 500 𝐹ൗ𝐴 , 5.063%, 14 = 500 19.6845 = $9842

Spreadsheet function: FV=FV(effect(5%,2),14,500)=$9841.93

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 Section 3.5 – Series with PP ≥ CP -
Example 3.5 1

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 Section 3.5 – Series with PP ≥ CP -
Example 3.5 1

P = $3M

• First step: Find P for n = 10 annual payments.

• Period is year.
• PP = year; CP = 6 months; PP > CP.
• Effective i per year  (1  0.08 / 2) 2  1  8.16%.
Relation: P = 3M + 200,000(P/A,8.16%,10) = $4,332,400
Access the text alternative for slide images.

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 Section 3.5 – Series with PP ≥ CP -
Example 3.5 2

P = $3M

• Second step: Find A for n = 20 semiannual amounts

• Period is 6 months.
• PP = 6 months; CP = 6 months; PP = CP.
• Effective i per 6 months = 8%/2 = 4%.
Relation: A = 4,332,400(A/P,4%,20) = $318,778 / 6- months.
Access the text alternative for slide images.

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 From Section 3.7 – Example 3.5
Solved via Spreadsheet
Use EFFECT to find effective rate and PV to find PW now:
= EFFECT (8%,2) displays i of 8.16%
= PV (8.16%,10,200000) – 3000000 displays $−4,332,385
Use PMT for n = 20 and i = 8%/2 = 4 to find semiannual A:
= PMT (4%, 20, PW_value) displays A = $318,784

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 Section 3.6 – Equivalence with Series
– PP < CP 1

Consider: Deposit money monthly (PP) with interest compounded

quarterly (CP)
Result: PP < CP
Usually, interest is not paid on interperiod deposits
For equivalence computations: Cash flows are ‘moved’ to
match CP time period

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 Section 3.6 – Equivalence with Series
– PP < CP 2

APPROACH NORMALLY TAKEN

Move cash flows as follows:
• Deposits (cash outflows) – move to end of period.
• Withdrawals (cash inflows) – move to beginning of same
period, which is the end of last period.

Example: Move monthly deposits to match quarterly

compounding.
Now, PP = CP = quarter
• Find P, F or A using effective i per quarter.

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 Section 3.6 – Series with PP < CP -
Example 3.6

Access the text alternative for slide images.

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 Section 3.6 – Series with PP < CP -
Example 3.6

Access the text alternative for slide images.

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 Section 3.6 – Series with PP < CP -
Example 3.6
Moving cash flows transforms upper diagram into bottom diagram

Access the text alternative for slide images.

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 Section 3.6 – Series with PP < CP -
Example 3.6

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 Section 3.7 – Spreadsheet Functions
for r and i Rates 1

Effective rate:
= EFFECT(nominal_rate, compounding_frequency
Nominal rate r must be expressed over same time period as that
of the requested effective rate.

Nominal rate:
= NOMINAL(effective_rate,
compounding_frequency_per_year)
This function always displays annual nominal rate; m must equal
times of compounding per year.

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 Section 3.7 – Spreadsheet Functions
for r and i Rates 2

Examples of using = EFFECT and = NOMINAL functions

This is Figure 3.6

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 Section 3.7 – Spreadsheet Functions
for r and i Rates – Example 3.5

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 Section 3.7 – Spreadsheet Functions
for r and i Rates – Example 3.5

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 Section 3.7 – Spreadsheet Functions
for r and i Rates – Example 3.5

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 Section 3.8 – Personal Finance -
Example 3.8

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 Section 3.8 – Personal Finance -
Example 3.8

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 Section 3.8 – Personal Finance -
Example 3.8

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 Section 3.8 – Personal Finance -
Example 3.8

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 Section 3.8 – Personal Finance -
Example 3.8
Credit balance of $4000; minimum monthly payment = $65; APR
= 16.65%; CP = daily.
Spreadsheet solves questions (c) through (e):
(b) Effective i per year  (1  0.1665 / 365)365  1  18.11%.
(c) Monthly interest = 4000(0.1665/12) $55.50.
(d) = NPER(16.65%/12,,−65,4000) displays n = 140 months.
(e) Total paid = 65(140) = $9100 to remove $4000 debt.

Access the text alternative for slide images.

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 Section 3.8 – Personal Finance -
Example 3.9

Access the text alternative for slide images.

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 Section 3.8 – Personal Finance -
Example 3.9 2

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 Section 3.8 – Personal Finance -
Example 3.9 2

Access the text alternative for slide images.

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 Section 3.8 – Personal Finance -
Example 3.10

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 Section 3.8 – Personal Finance -
Example 3.10

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 Section 3.8 – Personal Finance -
Example 3.10

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 Section 3.8 – Personal Finance -
Example 3.10

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 Section 3.8 – Personal Finance -
Example 3.11

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 Section 3.8 – Personal Finance -
Example 3.11

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 Section 3.8 – Personal Finance -
Example 3.11 2

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 Section 3.8 – Personal Finance -
Example 3.11 1

Statement: Invest $5000 of $10,000 graduation gift and add $50 per
month or $600 per year. Let it grow at a return of 5% for 40 years.
(a) Determine F value for $600 annually and $50 per month
$600 (cell F2):
= −FV(5%,40,600,5000) displays $107,680
$50 (cell F3):
= −FV(5%/12,40*12,50,5000) displays $113,093
(b) Reinvest 2.5% annual dividend and deposit $600 per year. What is
total in 40 years? (Neglect taxes, capital gains, and inflation.)
Spreadsheet displays total of $226,575 (cell F48) on a total invested of
only $29,000 over the 40 years.

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© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
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