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Chapter 4

Nominal and Effective Interest

Rates

Blank Leland and Tarquin Anthony, Engineering Economy, 7th

edition, McGraw-Hill International Edition, 2012

March, 2023 Dr. Mansour Abou Gamila 1

Learning Objectives
1. Understand nominal and effective interest rate statements.
2. Derive and use the formula for the effective annual interest
rate.
3. Determine the effective interest rate for any time period.
4. Determine the correct method for equivalence calculations
for different payment and compound periods.
5. Make equivalence calculations for payment periods equal to
or longer than the compounding period when only single
amount occur.
6. Calculate and use an effective interest rate for continuous
compounding.
7. Account for interest rates that vary over time when
performing equivalency computations.
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4.1 Nominal and Effective Interest Rate Statements

Time Standard
 One Year: Can be segmented into:
 365 days
 52 Weeks
 12 Months
 One quarter: 3 months – 4 quarters/year
 Interest can be computed more frequently than one
time a year

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4.1 Nominal and Effective Interest Rate Statements

General Questions
 Suppose that you deposited LE 2,000 in a savings
account at the beginning of a year where the annual
interest rate is 6%
1. What would be the future worth?
F
6%

0 1

BD 2,000

 Apparently, the end-of-year amount, F

 F = 2,000(1 + 0.06) = LE 2,120.000
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4.1 Nominal and Effective Interest Rate Statements

General Questions
2. What would be the future worth if the interest is compounded
monthly?
 For each month, we have an interest rate of 6% / 12 = 0.5%
F
6%

0 1

0.5% each

BD 2,000

 The future worth, F = P(1+i)12

 F = 2,000(1 + 0.005)12 = LE 2,123.356
 Thus, the annual effective interest rate = 6.17%

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4.1 Nominal and Effective Interest Rate Statements

General Questions
Thus, LE 2,123.356
 We have an annual
interest rate of 6% 6%
compounded
monthly 0 1

0.5% each
 OR - we have
monthly interest LE 2,000
rates of 0.5% for 12 LE 2,123.356
months
6.17%
 OR - we have a
6.17% interest rate 0 1
compounded
annually
LE 2,000

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4.1 Nominal and Effective Interest Rate Statements

Quotation of Interest Rates
 Two types of interest quotation
1. Quotation using a Nominal Interest Rate
2. Quoting an Effective Periodic Interest Rate
 Nominal and Effective Interest rates are common in
business, finance, and engineering economy
 Each type must be understood in order to solve
various problems where interest is stated in various
ways

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4.1 Nominal and Effective Interest Rate Statements

Nominal Rate of Interest, r
 An interest rate that does not include any consideration of
compounding (definition)
 For example, 6% per year is a nominal rate
 Each type must be understood in order to solve various
problems where interest is stated in various ways
 Mathematically:
 r = (interest rate per period)(No. of Periods)

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4.1 Nominal and Effective Interest Rate Statements

Examples – Nominal Interest Rates
 1.5% per month for 24 months
• Same as: (1.5%)(24) = 36% per 24 months
 1.5% per month for 12 months
• Same as (1.5%)(12 months) = 18% per year
 1.5% per month for 6 months
• Same as: (1.5%)(6 months) = 9% per 6 months or
semiannual period
 1% per week for 1 year
• Same as: (1%)(52 weeks) = 52% per year

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4.1 Nominal and Effective Interest Rate Statements

The Effective Interest Rate
 A nominal rate (so quoted) do not reference the
frequency of compounding
 The true Effective Interest Rate is then applied ...
 The effective interest rate is the actual rate that
applies for a stated period of time
 The effective rate is commonly expressed on an
annual basis denoted as “ia”

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4.1 Nominal and Effective Interest Rate Statements

Example: Effective Interest Rate
 “14 % compounded monthly”

 Pick this statement apart:

 14% is the nominal rate
 “compounded monthly” conveys the frequency of the
compounding throughout the year
 This example: 12 compounding periods within a year

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4.1 Nominal and Effective Interest Rate Statements

Necessary Definitions
 Time period (t): the period over which the interest is
expressed (1% per month or 12% per year)
 Compounding period (CP): the shortest time unit
over which interest is charged or earned or computed
(8% per year compounded monthly)
 Compounding frequency: the number of times m that
compounding occurs within the time period t (or
payment period)
 Payment period (PP): frequency of the payments or
receipts which is the cash flow transaction period

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4.1 Nominal and Effective Interest Rate Statements

Differences between Nominal and Effective Rates
 Nominal Rates:
• Format: “r% per time period, t”
• Ex: 5% per 6-months”

 Effective Interest Rates:

• Format: “r% per time period, compounded ‘m’ times a year
• ‘m’ denotes or infers the number of times per year that
interest is compounded
• Ex: 18% per year, compounded monthly

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4.1 Nominal and Effective Interest Rate Statements

r % per time period "t"
Effective rate per CP 
m compunding peiod per"t"
Assume r = 9% per year, compounded monthly, then m =12, the effective rate =
9%/12 = 0.75% per month, compounded monthly.

Ex. 4.1
Determine the effective rate of return on the basis of the compound period
for each rate?
a. 9% per year, compounded quarterly,
r= 9% per year, compounded period = quarter, m=4,
effective rate per CP = 9/4 = 2.25%,

b. 9 % per year, compounded monthly.

r= 9% per year, compounded period = Month, m=12,
effective rate per CP = 9/12 = 0.75%,

c. 4.5 % per 6 months, compounded weekly

r=4.5% per 6 months, compounded period = week, m = 26,
effective rate per CP = 4.5/26=0.173%
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4.2 Effective Annual Interest Rates

r = nominal interest rate per year
m= number of compounding periods per year
i= effective interest rate per compounding period(CP) = r/m
ia = effective interest rate per year

F  P (1  i ) m
1  ia  (1  i) m
The effective annual int erest rate  ia  (1  i) m  1  (1  r / m) m  1
If ia and compounding frequency " m" are known :
i  (1  ia )1/ m  1
i  r/m
r % per year  (i% per CP) (no. of CPs per year)  (i)(m)

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4.3 Effective Interest Rates For Any Time Period

r= nominal interest rate per payment period “PP”
m= number of compounding periods per payment period (CP per PP)

It is important to distinguish between compounding period and the

payment period because in many instances the two do not coincide.

Effective i  (1  r/m) m  1
CP CP
6 Months 6 Months
0 1 2 3 4 5 6 7 8 9 10 11 12
Months

PP
1 Months
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Example
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.
m=12, rate of 18% per year, compounded monthly. P= $1000, ia =?, F=?
i= 18%/12 = 1.5% per month
i a  (1 0.015)12  1  1.19562  1  0.19562
F  $1000(1.19562)  $1195.62
Compounded Times Compounded per Rate per Effective Annual Rate, ia
Period Year, m Compounded
Period, i

Year 1 18% (1.18)1  1  18%

6 months 2 9% (1.09) 2  1  18.81%

Quarter 4 4.5% (1.045) 4  1  19.252%

Month 12 1.5% (1.015)12  1  19.562%

Week 52 (1.0034615)52  1  19.684%

March, 2023 Dr. Mansour0.34615%
Abou Gamila 17

Ex. 4.6, Page 106

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.

r = 0.18, and m = 365

365
 0.18 
Effective i % per year  1  -1 19.716%
 365 
r  0.09 per 6 - months and m 182 days,
182
 0.09 
Effective i% per 6 months  1    1  9.415 %
 182 

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4.4 Equivalence Relations: Comparing

Payment Period and Compounding Period
Lengths (PP versus CP)
• The frequency of cash flows does not equal the frequency of
interest compounding. Cash flows may occur monthly, and
compounding occurs annually, quarterly, or more often.

• Consider deposit made to a saving account each month, while

the earning rate is compounded quarterly. The length of the CP
is a quarter, while the PP is month. It is essential that the
compounding period and payment period be placed on the
same time bases, and that the interest rate be adjusted
accordingly.
• When PP =CP, and PP> CP. The equations to determine i and
n are the same.

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4.5 Equivalence Relations: Single Amounts

With PP≥CP
• Method 1 : Determine the effective interest rate over the
compounding period CP, and set n equal to the number of
compounding periods between P and F.
P = F(P/F, effective i% per CP, total number of periods n)
F = P(F/P, effective i % per CP, total number of periods n)

Method 2: Determine the effective interest rate for the time

period t of the nominal rate, and set n equal to the total number
of periods using this same time period.
Ex: Credit card rate 15% per year, compounded monthly, the time
period t is 1 year. 12
 0.15 
Effective i % per year  1   -1 16.076%
 12 
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Example-4-7, Page 108

An engineer working as a private consultant made
deposits into a special account to cover unreimbursed
travel expenses. Figure below shows the cash flow
diagram. Find the amount in the account after 10 years
at an interest rate of 12% per year, compounded
semiannually.

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Solution F =?

0 1 2 3 4 5 6 7 8 9 10

$1000
$1500 i=12% per year compounded
$3000 semiannually
Method 1:
Use the semiannual CP to express the effective semiannual rate of 6%
per 6-month period. n=2(number of years)
F = 1000(F/P,6%,20)+3000(F/P, 6%, 12)+1500(F/P,6%,8)
= 1000(3.2071)+3000(2.0122)+1500(1.5938) = $11,634
Method 2:
Express the effective rate based on semiannual compounding
2
 0.12 
Effective i % per year  1   -1 12.36%
 2 
F= 1000(F/P,12.36%,10)+3000(F/P, 12.36%, 6)+1500(F/P,12.36%,4)
= 1000(3.2071)+3000(2.0122)+1500(1.5938) = $11,634
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Example 4.8 page 109

For the past 7 years, a quality manger has paid $ 500 every 6 months for
the software maintenance contract of a LAN. What is the equivalent
amount after the last payment, if these funds are taken from a pool that has
been returning 8% per year, compounded quarterly?
F=?
i=8% per year compounded quarterly
0 1 2 3 4 5 6 7 Years

A=$500

The payment period(6 months) is longer than the compounding period

(quarter); PP>CP
r=4% per 6 month period and m=2 quarters per semiannual period.
2
 0.04 
Effective i % per 6 months  1   -1  4.04%
i= 4.04%, n=2*7=14  2 
F=A(F/A,4.04%,14)=500(18.3422)=$9171.09
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Chapter 4-Examples
Example
Suppose you plan to purchase a car and carry a loan of $12500 at
9% per year, compounded monthly. Payment will be made
monthly for 4 years. Determine the monthly payment.

The PP and CP are both a month

The effective interest per month=9%/12=0.75%
The number of payments=4*12=48
A=A(A/P,0.75%,48) = 12500(0.02489) = $311.13

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Chapter 4-Examples
• Example :
• Radio Frequency Identification (RFID) is technology that is
used by drivers with speed passes at toll booths and ranchers
who track livestock from farm to fork. Wal-Mart expects to
begin using the technology to track products within its stores.
If RFID-tagged products will result in better inventory
control that will save the company $1.3 million per month
beginning 3 months from now, how much could the company
afford to spend now to implement the technology at an
interest rate of 12% per year, compounded monthly, if it
wants to recover its investment in 2½ years?

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Chapter 4-Examples

• Solution:

• Interest rate = 12% per year (compounded monthly)

• Then, i = 12% / 12 = 1% per month
• Recovery period = 2½ years = 30 months

• P = 1.3(P/A,1%,28)(P/F,1%,2)
$ 1.3 million
 (1  i ) n  1 
• = 1.3
P  A n 
for -ni  1.0% per
(1+i)
 i (1  i )  month

0 1 2 3 4 5 6 28 29 30
= $30,988,577.00
P

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