Chapter 3

Understanding Money
Management
 Nominal and
Effective
Interest Rates
 Equivalen
ce
Calculatio
ns
 Changing
Interest Rates
 Debt 1

Management
Focu
s1. If payments occur more frequently than
annual, how do we calculate economic
equivalence?
2. If interest period is other than annual,
how do we calculate economic
equivalence?
3. How are commercial loans
structured?
4. How should you manage your debt?

2
Understanding
Money
Management
 Financial institutions often
quote interest rate based
on an APR(annual
percentage rate).
 In all financial analysis, we
need to convert the APR into
an appropriate effective
interest rate based on a
payment period.
 When payment period and 2

interest period differ, calculate

 Understanding
Money
Management
Example: Nominal interest rate 18% compounded monthly.

This statement means simply that each month the bank will charge 1.5% interest (12 months per
year X 1.5% per month = 18% per year) on the unpaid balance. As shown in Figure 3.1, we say
that 18% is the nominal interest rate or annual percentage rate (APR) and that the
compounding frequency is monthly (12 times per year).

4
Understanding Money
Management
Nominal Versus Effective
Interest Rates

Nominal Effective
Interest Rate: Interest Rate:
Interest rate Actual interest
quoted based on earned or paid in
an annual a year or some
period other time period

6
18% Compounded
Monthly

Nominal Interest
interest rate period

Annual
percentage
rate 7

(APR)
Effective Annual Interest Rate
(Annual Effective Yield)
M
ia  (1  r / M )
1
r = nominal interest rate per
year
ia = effective annual interest
rate M =Year
number
1 Year 2of interest
Year 3
periods0 per
1 2 3 4 5
8
6 7 9
12
10 11
8
year
Practice
Problem
If your credit card calculates the
interest based on 12.5%
compounded monthly. What is
your monthly interest rate and
annual effective interest rate,
respectively?

9
 Solutio
nMonthly Interest Rate:
12.5%
i  12
Annual Effective Interest 1.0417%
Rate: i  (10.010417)12 -1 13.24%
a

10
Practice
Problem
 Suppose your savings account

pays 9% interest compounded

quarterly. If you deposit $10,000
for one year, how much would
you have?

11
 Solutio
n (a) Interest rate per quarter:

9%
i 4 
2.25%
(b) Annual effective interest rate:
ia  (1  0.0225)4  1 
9.31%
(c) Balance at the end of one year (after 4 quarters)

F  $10, 000( F / P, 9.31% ,1)

 $10, 931
12
Effective Annual Interest
(9%
Ratescompounded quarterly)
Base amount $10,000
First quarter
+ Interest (2.25%) + $225

= New base = $10,225

Second amount +$230.06
quarter + Interest (2.25%)
= New base = $10,455.06
Third quarter amount +$235.24
+ Interest (2.25%)
= New base = $10,690.30
Fourth amount + $240.53
quarter + Interest (2.25 %)
= Value after = $10,930.83
one year
13
 Nominal and Effective Interest
with
RatesDifferent Compounding
Periods
Effective Rates
Nomin Compoun Compoun Compoundi Compoundi Compoundi
al di ng di ng ng ng ng
Rate Annually Semi- Quarterly Monthly Daily
annually
4% 4.00% 4.04% 4.06% 4.07% 4.08%
5 5.00 5.06 5.09 5.12 5.13
6 6.00 6.09 6.14 6.17 6.18
7 7.00 7.12 7.19 7.23 7.25
8 8.00 8.16 8.24 8.30 8.33
9 9.00 9.20 9.31 9.38 9.42
10 10.00 10.25 10.38 10.47 10.52
11 11.00 11.30 11.46 11.57 11.62
14
12 12.00 12.36 12.55 12.68 12.74
What happens if we pay in some period of time but
we have interest rate per a different period??

Annual interest rate

Compounding Period

Payment Period

15
 12% compounded monthly!!!!!Formula or converting to
interest
Payment Period = Quarter periods to payment periods
Compounding Period = Month
Find annual effective interest
rate?
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

1% 1% 1%
3.030 %
One-year
• Effective interest rate per quarter
iq  (1  0 .01 ) 3  1 
3 .030
% quarterly
• Effective annual interest rate
1
8
OR monthly
Effective Interest Rate per
Payment Period (i)

i  [1 r / CK] C

1 of interest periods per

C = number
payment period
K = number of payment periods
per year
M = number of interest periods per year
(M=CK)
17
 Case 0: 8% compounded quarterly
Payment Period = Quarter
Interest Period = Quarterly
1st Q
2nd Q 3rd Q 4th Q

1 interest period Given r = 8%,

iq=%8/4=%2

İq’  [1  iq] 1 1
 2 . 0 0 0 % pe r
q u a r te r
18
Case 1: 8% compounded monthly
Payment Period = Quarter
Interest Period =
Monthly
1st Q
2nd Q 3rd Q 4th Q

3 interest periods Given r = 8%, Firstly turn nominal

interest rate to interest period.
im=%8/12=%0.6
Secondly turn the interest rate
iq  [1  im]  1
3
to payment period as
effective interest rate

 2 . 0 1 3 % pe r q u a r te
19
r
Case 2: 8% compounded weekly
Payment Period = Quarter
Interest Period = Weekly
1st Q
2nd Q 3rd Q 4th Q

13 interest periods
Given r = 8%,
iw=%8/52=%2
iq  [1  iw] 1 3  1

2 .0186% pe
r q u a rte r
20
Case 3: 8% compounded continuously
Payment Period = Quarter
Interest Period = Continuously

1st Q
2nd Q 3rd Q 4th Q

 interest periods
Given r = 8%,
K = 4 payments per year

i  er / K  1
1
0.02

 e2.0201 % per
21
quarter
 Summary: Effective interest rate
per
quarter
Case 0 Case 1 Case 2 Case 3

8% 8% 8% 8%
compound compound compound compound
ed ed ed weekly ed
quarterly monthly continuous
ly
Payments Payments Payments Payments
occur occur occur occur
quarterly quarterly quarterly quarterly
2.000% 2.013% 2.0186% 2.0201%
per per per per
quarter quarter quarter quarter
22
 How many weeks are
there in a quarter?

Practice Many firms define their

fiscal quarters as 13-
week periods.
 Example
1000 YTL initial deposit.

Effective interest rate per quarter

Balance at the end of 3 years for a
nominal rate of 8% compounded
weekly?
iw= 8% /52

iq  (1 1  2.0186% per

How many
iw)13 quarter quarters are there
F  1000(F | P, iq , 12) in 3 years?
4*3=12

23
 How many days are
Practice there in a quarter?
365/4
 Example
1000 YTL initial deposit.

Effective interest rate per quarter

Balance at the end of 3 years for a
nominal rate of 8% compounded
daily?
id= 8% /365

iq  (1 id)365/4-1=%2.0199 How many

quarters are there
in 3 years?
F  1000(F | P, iq ,12) 4*3=12

24
 We have to turn the
continuous
Practice compounded version
to quarters

Example
1000 YTL initial deposit.

Effective interest rate per quarter

Balance at the end of 3 years for a
nominal rate of 8% compounded
continuously?
r 0.08
i e k
1  e 4 1 
2.0201% per quarter
How many
quarters are there
in 3 years?
4*3=12

F  1000(F | P, 2.0201%,12)
25
 Practice
 Example
2000 YTL borrowed. How much must be
returned at the end of 3 years if i=6%
compounded monthly?
12
0.06 How many
Interest
F  2000 rate
( Fper 0.5%,m) 
| P,month(i  0.005
months are
36) there in a year?
or
Effective interest rate per year  ( 1 im )12  1  6.168 %

F  2000 ( F | P, 6.168 %, How many years

are there in 3
3) years?

or How many
months are the
Effective interest rate per quarter  (1+ im )3 1  1.5075 %
in a quarter?
F  2000 ( F | P,1.5075 %, How many
2
quarters are 8
12) there in 3 years?
Equivalence Analysis using
Effective Interest Rate
 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. 27
Principle: Find the effective
interest rate that covers the
payment period
Case 1: compounding period = payment period

Case 2: compounding period < payment period

Case 3: compounding period > payment period

28
 When Payment Periods and
Compounding periods coincide
< 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
< Step 4: Use the appropriate interest formula
using i and N above
29
 When Payment Periods and Compounding periods
coincide Payment Period = Interest Period

$20,000
1 2 3 48
0 4
A
Given: P = $20,000, r = 8.5% per year compounded monthly

Find A (monthly payments)

< Step 1: M = 12
< Step 2: i = r/M = 8.5%/12 = 0.7083% per month
< Step 3: N = (12)(4) = 48 months
< Step 4: A = $20,000(A/P, 0.7083%,48) = $492.97
30
 Dollars Up in
Smoke
What three levels of smokers who bought cigarettes every
day for 50 years at $1.75 a pack would have if they had
instead banked that money each week: (Show that?)
Level of smoker Would have had
1 pack a day $169,325

2 packs a day $339,650

3 packs a day $507,976

Note: Assumes constant price per pack, the money banked weekly and an
annual interest rate of 5.5%
Source: USA Today, Feb. 20, 1997 3
3
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 equivalence value.

Weekly deposit amount
A = $1.75 x 7 = $12.25 per week
Total number of deposit periods
N = (52 weeks/yr.)(50 years)
= 2600 weeks

F = $12.25 (F/A, 0.10577%, 2600)=

$169,325
32
Compounding more frequent than
payments Discrete Case Example:
Quarterly deposits with monthly
compounding
Suppose you make equal quarterly
deposits of $1000 into a fund that
pays interest at a rate of 12%
compounded monthly. Find the
balance at the end of year three.
Payment period= quarter
Interest period= monthly

33
Compounding more frequent than
payments Discrete Case Example:
Quarterly deposits with monthly
compounding
Year 1 Year 2 Year 3
F=?
0 1 2 3 4 5 6 7 9 10 11
8 12
Quarters

A = $1,000
Step M = 12 compounding
1: periods/year
C
K=4 3 payment
interest periods per
periods/year
quarter Step 2: i  [1  0.12 /(3)
(4)]3  1
Step =
N = 4(3) 3.030
12 %
3: F = $1,000 (F/A, 3.030%,
Step 12)
4: = $14,216.24 34
Continuous Case: Quarterly deposits
with Continuous compounding

Suppose you make equal quarterly

deposits of $1000 into a fund that
pays interest at a rate of 12%
compounded continuously. Find
the balance at the end of year
three.

35
Continuous Case: Quarterly deposits
with Continuous compounding

Year 1 Year 2 Year 3

F=?
0 1 2 3 4 5 6 7 9 10 11
8 12
Quarters

A = $1,000
Step K = 4 payment
1: periods/year C =  interest
periods per quarter i  e0.12/4
Step
2:
1
Step
3:  3.045% per quarter
Step
N = 4(3) = 12 36
4:
F = $1,000 (F/A, 3.045%, 12)
 Compounding less frequent than
payments
 Suppose you make $500 monthly
deposits to an account that pays
interest at a rate of 10%, compounded
quarterly. Compute the balance at the
end of 10 years.
i  (1 0.10 / 4)1/ 3 1  per month
0.826%
Whenever a deposit is made, it
F  500(F | A,0.826%,120)  starts to earn interest.
101907.89

37
 Credit Card

Debt
Annual
fees
 Annual
percenta
ge rate
 Grace
period
 Minimu
m
payme 4

nt 0
 Methods of Calculating Interests on your
Credit Card

Method Description Interest You Owe

Adjusted Balance The bank subtracts the amount Your beginning balance is
of your payment from the $3,000. With the $1,000
beginning balance and charges payment, your new balance
you interest on the remainder. will be $2,000. You pay 1.5%
This method costs you the on this new balance, which
least. will be $30.
Average Daily The bank charges you interest on Your beginning balance is
the average of the amount you $3,000. With your $1,000
Balance owe each day during the period. payment at the 15th day, your
So the larger the payment you balance will be reduced to
make, the lower the interest you $2,000. Therefore, your
pay. average balance will be
(1.5%)($3,000+$2,000)/2=$37
.50.
Previous Balance The bank does not subtract any Regardless of your payment
payments you make from your size, the bank will charge
previous balance. You pay 1.5% on your beginning
interest on the total amount you balance $3,000: (1.5%)
owe at the beginning of the ($3,000)=$45.
period. This method costs you
the most. 41
 Commercial
Loans
< Amortized Loans
• Effective interest rate specified
• Paid off in installments over time (equal periodic amounts)
• What is the cost of borrowing? NOT necessarily the loan
with lowest payments or lowest interest rate. Have to look
at the total cost of borrowing (interest rate and fees,
length of time it takes you to repay (term))

40
Auto
Loan
$20,000

1 2 24 25 48
0

Given: APR = 8.5%, N = 48 months, and

P = $20,000 im=8.5%/12
Find: A
A = $20,000(A/P,%im,48)
= $492.97
41
Suppose you want to pay off the remaining
loan in lump sum right after making the
25th payment.
How much would this lump be?
$20,000

1 2 24 25
48
$492.97 $492.97
0
25 payments that were 23 payments that are
already made still outstanding

P = $492.97 (P/A, 0.7083%, 23)

= $10,428.96 4
4
For the 33rd payment, what is the interest
payment and principal payment?

Remaining
492.97(P | A,8.5% /12,16)  balance after
32
7431.12 payments
Interest
7431.12(0.0071)  component of the
52.76 33rd payment

492.97  52.76  Principal payment

component of the
440.21 33rd payment

43
 Buying versus Lease
Decision
Option 1 Option 2
Debt Lease
Financing Financing
Price $14,695 $14,695
Down payment $2,000 0
APR (%) 3.6%
Monthly payment $372.55 $236.45
Length 36 months 36 months
Fees $495
Cash due at lease end $300
Purchase option at $8.673.10
lease end
44
Cash due at signing $2,000 $731.45
6% compounded monthly

45
 Which Option is
Better?
 Debt Financing:
Pdebt = $2,000 + $372.55(P/A, 0.5%, 36)
- $8,673.10(P/F, 0.5%, 36)
= $6,998.47
 Lease Financing:
Please = $495 + $236.45 + $236.45(P/A,
0.5%, 35)
+ $300(P/F, 0.5%, 36)
= $8,556.90
46
 Exampl
e
 Suppose you borrowed $10000 at
an interest rate of 12%
compounded monthly over 36
months. At the end of the first
year (after 12 payments), you
want to negotiate with the bank to
pay off the remainder of the loan
in 8 equal quarterly payments.
What is the amount of this
quarterly payment, if the interest
rate and compounding frequency 47
Example
Solution
A  10000( A | P,1%,36)  332.14
Remaining debt (end of 1st)  332.14(P | A,1%,24) 
7055.77
Effective rate per quarter  (1 0.01)3 1  3.03%
A  7055.77( A | P,3.03%,8)  1006.41per quarter

48