Ch.

4 : Nominal and Effective

Interest Rates

Interest rate has been a constant, annual

value
Sometimes, interest rate compounded less
than a year; monthly, weekly, quarterly
introduce new term : nominal and effective
interest rate

The statements
interest is compounded more than once a
year
effect of compounding more frequently is
present

Nominal Interest rate

an interest rate that does not include any

consideration of compounding
r = interest rate per period x no. of period
[4.1]

A nominal rate r may be stated for any time

period : 1 year, 6 months, quarter, month, etc

Example,
the nominal rate of r = 1.5% per month is the
same as :
r = 1.5% per month x 24 month
= 36% per 2-year period
r = 1.5% per month x 12 month
= 18% per year
r = 1.5% per month x 0.231 month
= 0.346% per week

Effective Interest Rate

is the actual rate that applies for a stated

period of time
has the compounding frequency attached to
the nominal rate statement
if not stated, it is assume to be the same as
the time period of r, nominal and effective
rates have the same value

The following are nominal rate statement; have

different effective interest rate value due to
the different compounding frequencies.
4% per year, compounded monthly
12% per year, compounded quarterly
9% per year, compounded daily
3% per quarter, compounded monthly
6% per 6 month, compounded weekly
3% per quarter, compounded daily

Determine the effective interest rate before

performing engineering economy study

Three time-based units with an interest rate

statement,
time period,
period the period over which the
interest is expressed. This is the t in the
statement
compounding period (CP), the shortest time
unit over which interest rate is charged or
earned
compounding frequency,
frequency the number of time
that m compounding occurs within the time
period t.

Example

The rate of 8% per year, compounded

monthly
it has time period t = 1 year

compounding period CP = 1 month

compounding frequency m = 12 times

per year

A rate of 6% per year, compounded weekly

has t = 1 year

CP = 1 week

m = 52

The corresponding effective rate per CP is

r per time period t
r
Effective rate per CP =
=
m compounding periods per t m

Assume r = 9% per year,

compounded monthly; then m = 12
from the equation CP = r/m,
the effective rate = 9%/12 = 0.75% per month
Note

changing the basic time period t does not

alter the compounding period

Example 4.1
The different bank loan rates for the separate
electric generation equipment projects are
listed below. Determine the effective rate on
the basis of the compounding period for each
quote.
a) 9% per year, compounded quarterly
b) 9% per year, compounded monthly
c) 4.5% per 6-months, compounded weekly

Solution
Apply equation Effective rate per CP = r/m to
determine the effective rate per CP for
different compounding frequencies.
Nominal
r% per t
a) 9% per year
b) 9% per year
c) 4.5% per 6month

compounding
period

Effective
rate per CP

quarter
month
week

4
12
26

2.25%
0.75%
0.17%

Various Ways to Express Nominal and

Effective Interest Rates
Format of
Rate Statement

What about the

Effective Rate?

Examples of Statement

Nominal rate stated,

compounding period stated

8% per year,
compounded quarterly

Effective rate stated

Effective 8.243% per year, Use effective rate directly

compounded quarterly

Interest rate stated, no

compounding period stated

8% per year,
or
2% per quarter

Find effective rate

Rate is effective only

for time period stated;
find effective rate for all
other time period

Effective Annual Interest Rates

The symbols used
r = nominal interest rate per year
m = no. of compounding periods per year
i = effective interest rate per compounding
period (CP) = r/m
ia = effective interest rate per year

Effective annual interest rates

treat nominal and effective interest rate

parallels that of simple and compound
interest
Future worth for compound interest
F = P(1 + i)
n

Since interest may be compounded several

times, replace i with ia; the relation for F at
the end of year 1:
F = P + Pia = P(1 + ia)
[4.3]

Future worth calculation at a rate i,

compounded m times
P(1+i)
in a year
P(1 + i)

P(1 + i)
P(1 + i)
P(1 + i)

= P(1+ia)

m-1

m-2

Future worth
amounts

P(1 + i)

P
i

m2 m1
Compounding period

i
m

Effective i per
compounding period

the rate i per CP must be compounded

through all m periods,

F = P(1 + i)

[4.4]
m

If, P = $, then by equating F = (1 + i) ,and

F = 1 + ia, the effective annual interest rate
formula for ia can be derived
1 + ia = (1+ i)
ia = (1 + i) 1
[4.5]
m

If the effective annual rate, ia and

compounding frequency m are known, the
effective interest rate per compounding
period is,
i = (1 + ia) 1
[4.6]
1/m

to determine the nominal annual rate r, using

the definition of i stated above, namely, i =
r/m,
r% per year = (i% per CP)(no. of Cps per
year) = (i)(m)
[4.7]

Example 4.2
Jacki obtained a new credit card from a
national bank, MBNA, with a stated rate of
18% per year, compounded monthly. For a
$1000 balance at the beginning of the year,
find the effective annual rate and the total
amount owed to MBNA after 1 year,
provided no payments are made during the
year.

Solution
There are 12 compounding periods per year.
Thus, m = 12 and
i = 18%/12 = 1.5% per month
For a $1000 balance that is not reduced during
the year, apply eq. [4.5] then [4.3] to provide
Jacki with the information.
12

ia = (1 + 0.015) -1 = 1.19562 -1 = 0.19562

F = $1000(1.19562) = $1195.62
Jacki will pay 19.562% or $195.62 plus the
$1000 balance, for the use of the bank's
money during the year

Effective Interest Rate for Any

time Period

known compounding period (CP)

new term : payment period (PP), the
frequency of the payments or receipts
to evaluate cash flow with PP < 1 year,
effective interest rate over PP must be used
m

Effective i = (1 + r/m) 1
where:

[4.8]

r = nominal interest rate per payment period (PP)

m = number of compounding periods per payment
period (CP per PP)

Example
A company deposits money each month into
an account that pays a nominal interest rate
of 14 % per year, compounded semiannually, the payment period is 1 months
while the compounding period is 6 months
r = nominal 14% per year, compounded semiannually
CP
6 months

CP
6 months
0

PP
1 month

10

11

12

Months

Example 4.4
Visteon, a spin-off company of Ford Motor
Company, supplies major automobile
components to auto manufacturers
worldwide and is Ford's largest supplier. An
engineer is on a Visteon committee to
evaluate bids for new-generation coordinate
measuring machinery to be directly linked to
the automated manufacturing of highprecision components. Three vendor bids
include the interest rate on the next page.
Visteon will make payments on a
semiannual basis only.

The engineer is confused about the effective

interest rates what they are annually and
over the payment period of 6-months.
Bid #1: 9% per year, compounded quarterly
Bid #2: 3% per quarter, compounded
quarterly
Bid #3: 8.8% per year, compounded monthly
(a) Determine the effective rate for each bid
on the basis of semiannual payments, and
construct cash flow diagram
(b) What are the effective annual rates? There
are to be part of the final bid selection

c) Which bid has the lowest effective annual

rate ?
Solution
(a) Set the payment period (PP) at 6-month,
PP = 6 months
r = 9% per year = 4.5% per 6-months
m = 2 quarters per 6-months
Effective i% per 6-months =

0.45 2
1

-1

= 1.0455 1
= 4.55%

Table 4-4 Effective Semiannual and Annual

Interest Rates for Three Bid Rates

Bid
#1
#2
#3

Semiannual Rates
Nominal per CP per
6 Months, r
PP, m
4.50%
6.00%
4.40%

2
2
6

Effective i
Equation [4.8]

Nominal per
Year, r

4.55%
6.09%
4.48%

9.00%
12.00%
8.80%

Annual Rates
CP per
Effective i
Year, m Equation [4.8]
4
4
12

Cash flow diagram for bid 1 and bid 2

CP
1quarter

CP
1quarter

CP
1quarter

1
PP
6 Months

CP
1quarter
4

PP
6 Months

9.31%
12.55%
9.16%

Cash flow diagram for bid 3

CP = 1 month
1

PP
6 Months

10 11 12

PP
6 Months

b) For the effective annual rate, the time basis

in Equation [4.8] is 1 year. This is the same
as PP = 1 year. For bid #1,
r = 9% per year
m = 4 quarters per year
4

0.09
Effective i% per year = 1 4 1 = 9.31%

c) Bid #3 includes the lowest effective annual

rate of 9.16%, which is equivalent to an
effective semiannual rate of 4.48%
Comment

The effective rates for bid #2 only may be found

directly in tables 4-3. For the effective semiannual
rate, look at the nominal 6% under m = 2, which is
the number of quarters per 6 months. The effective
semiannual rate is 6.09%. Similarly, for the nominal
12% rate, there are m = 4 quarters per year, so
effective annual i = 12.551%. Although Table 4-3
was originally designed for nominal annual rates, it
is correct for other nominal rate periods, provided
the appropriate m value is included in the column
headings.

Example 4.5
A dot-com company plans to place money
in a new venture capital fund that
currently returns 18% per year,
compounded daily. What effective rate is
this (a) yearly and (b) semiannually?

Solution
(a) Use Eq. [4.8], with r = 0.18 and m = 365
365

Effective i% per year = 1 0.18 1

365

=19.716%
(b) Here r = 0.09% per 6-months and m = 182
days
182

0.09
1
Effective i% per 6 months = 1
182

= 9.415%

Interest Rates that Vary Over

Time

Real-world situation, interest rate vary over

time
Depends upon financial health, market
sector, national and international economy,
forces of inflation, and other
Loan rates may increase

When P,F, and A values calculated using a

constant interest rate, fluctuation in i are
neglected
If the variation in i is large, the equivalent
values will be different
To determine P value for Ft at different it
values for each year t, assume annual
compounding. Define
it = effective annual interest rate for year t
(t = years 1 to n)

To determine the present worth, calculate P

of each Ft value, using the applicable it, and
sum the results.
P = F1(P/F,i1,1) + F2(P/F,i1,1)(P/F,i2,1) +...
+ Fn(P/F,i1,1)(P/F,i2,1)...(P/F,in,1)
[4.13]
When only single amounts P and F are
involved,
P = Fn(P/F,i1,1)(P/F,i2,1)...(P/F,in,1)
[4.14]

If A is needed

find P
substitute symbol A for each F symbol
t

equivalent P has been determined, only

one unknown A
If there is a cash flow in year 0, interest rate
vary annually; this cash flow must be
included to determine P
For the computation of equivalent uniform
series A, also include the initial cash flow at t
=0
Insert the factor value (P/F,i0,0), which have
value of 1.00

Example 4.13
CE, inc., leases large earth tunneling equipment.
The net profit from equipment for each of the
last 4 years has been decreasing, as shown
below. Also shown are the annual rates of
return on invested capital. The return has been
increasing. Determine the present worth P and
equivalent uniform series A of the net profit
series. Take the annual variation of rates of
return into account.

Year
Net Profit
Annual Rate

1
$70,000.00
7.00%

2
$70,000.00
7.00%

3
$35,000.00
9.00%

4
$25,000.00
10.00%

Solution
Figure below shows the cash flows, rates for each
year, and the equivalent P and A.
$70,000

A=?

$35,000
$25,000

1
7%

P=?

2
7%

3
9%

1
7%

10%
$172,816

2
7%

3
9%

4
10%

Equation [4.13] is used to calculate P. Since for

both years1 and 2 the net profit is $70,000 and
the annual rate is 7 %, the P/A factor can be
used for these 2 years only.
P = [70(P/A,7%,2) + 35(P/F,7%,2)(P/F,9%,1)
+ 25(P/F,7%,2)(P/F,9%,1)(P/F,10%,1)](1000)
= [70(1.8080) + 35(0.8013) +
25(0.7284)](1000)
= $172,816

To determine an equivalent annual series,

substitute the symbol A for all net profit
values on the right side of Equation [4.15],
set it equal to P = $172,816 and solve for A.
This equation accounts for the varying i
values each year.
$172,816 = A[(1.8080) + (0.8013) + (0.7284)]
= A[3.3377]
A = $51,777