ISE 211

Engineering Economics

Chapter 4

Examples

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 Review last lecture
Compounding period (CP) – Shortest time unit over which interest
is charged or earned. e.g., 10% per year compounded monthly.

Compounding frequency (m) – Number of times compounding

occurs within the interest period t. e.g., at i = 10% per year,
compounded monthly, interest would be compounded 12 times
during the one-year interest period.

r – nominal interest rate per year

i – effective interest rate per year compounding period = r/m

ia – effective interest rate per year

Payment Period (PP) – Length of time between cash flows

(inflows and outflows) [determine if PP≥ CP or PP < CP
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 Formulas

Nominal rate per interest period r = interest rate per CP × number of CPs

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑟

𝒓𝒂𝒕𝒆 𝒑𝒆𝒓 𝑪𝑷= 𝑁𝑜𝑚𝑖𝑛𝑎𝑙𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝐶 = =
𝑐𝑜𝑚𝑝𝑜𝑛𝑑𝑖𝑛𝑔 𝑓𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 𝑚

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 Formulas
Equivalent Single Amounts (PP ≥ CP)
Method 1:
Determine 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 CPs n)

F= P(F/P, effective i% per CP, total number of CPs n)

Method 2: Determine effective interest rate for any time period t

(usually annually), and set n equal to the total number of those
same time periods

• When cash flows involve a series (i.e., A, G, g) and PP ≥ CP:

– Find the effective i per PP
– Determine n as the total number of PPs

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 Formulas
Equivalent Single Amounts or Series (PP < CP)
• Inter-period cash flows earn no interest (common)
– positive cash flows are moved to the beginning of the CP
– negative cash flows are moved to the end of the CP
• Inter-period cash flows earn compound interest (not common)
– cash flows are not moved and equivalent P, F, and A values are
determined using the effective interest rate per PP

Continuous compounding

Varying Rates

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 Spreadsheet Functions

• Effective Rate for any time period

= EFFECT(nominal_rate,compounding_frequency)
= EFFECT(r%, m)
(the nominal rate r must be expressed over the same
period of time as that of the e ffective rate)
• Nominal Rate for one year
= NOMINAL(effective_rate per year,
compounding_frequency_per_year)
= NOMINAL(ia%, m)
(always a nominal annual rate, m: times of
compounding annually)
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 Example 1

• 4.14 A company was told that the interest rate

on a loan would be an effective 3.5% per
quarter, compounded monthly. The owner,
confused by the terminology, asked you to help.
What is the (a) APR, and (b) APY? (c) Explain
how the EFFECT and NOMINAL functions can
or cannot be used to find the APR and APY.

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 Example 1
4.14(a) i = effective rate per quarter
r = nominal rate per quarter
m = quarter / month = 3
iq = (1+rq/mq)m-1 3.5% = (1+r/3)3-1
rq=3.46% per quarter
APR = ra = rq * 4 quarters =13.8% per year

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 Example 2

• 4.16. A credit card has an APR of 16% and an

APY of 16.64%. (a) What is CP? (b) Use the
EFFECT function to find CP.

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Example 2

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 Example 3

• 4.20 Videotech wants to have $65 million

available in 3 years to pay stock dividends.
How much money must the company set aside
now in an account that earns interest at a rate
of 12% per year, compounded quarterly? Solve
using (a) tabulated factors, and (b) a
spreadsheet function.

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 Example 3
F=$65 mil
CP=quarter 12% per year, compounded
quarterly
0
1 2 3 years
P= ?
P = F(P/F, effective i% per CP, total number of CPs n)

r = 12% per year, CP=quarter, m=12/3=4

Effective rate per CP: i = r/m =12%/4 = 3%
n = 3*4 =12 CPs

(b) =PV(i%, n, A, F)
=PV(3%,12, ,65000000)
0 =-$45,589,692

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 Example 4

• 4.26 A piece of Pollution control equipment is

estimated to cost $190,000 two years from now
and an additional $120,000 four years from
now. If Monongahela Power wants to set aside
enough money now to cover these future costs,
how much must be invested at an interest rate
of 8% per year, compounded semiannually?

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 Example 4
P=? 8% per year, compounded semiannually
CP=semiannual
2 4 years
0
1 3
190,000 120,000
P = F(P/F, effective i% per CP, total number of CPs n)

r = 8% per year, CP=semiannual, m=12/6=2

Effective rate per CP: i = r/m =8%/2 = 4%
n1 = 2*2 =4 CPs, n2 = 2*4 =8 CPs

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 Example 5

• 4.41 A manufacturer borrowed $2 million to

renovate one of its testing labs. The loan will be
repaid in 2 years through quarterly payments
that increases by $50,000 each time. At an
interest rate of 12% per year, compounded
quarterly, what will be the size of the first
quarterly payment?

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 Example 5
PT = 2,000,000
r = 12% per year
CP=quarter
PP=CP=quarter
12% per year CP1 CP2 CP3 CP4... CP8 m=12/3=4
0
Compounded Effective rate per CP:
quarterly i = r/m =12%/4 = 3%
A n = 2*4 =8 CPs
A+G
A+2G
A+3G
A+(n-1)G
PA = ? PG = ?
CP1 CP2 CP3 CP4 CP8 CP1 CP2 CP3 CP4 CP8
... ...
+
G=
A A A A A 50,000
2G
PA = A(P/A, effective i% per CP, total number of CPs n) 3G
(n-1)G
PG= G(P/G, effective i% per CP, total number of CPs n)

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 Example 6

• 4.48 How much would your parents have to

deposit each month into an account that grows
at a rate of 12% per year, compounded
semiannually, if they want to have $80,000 at
the end of year 3 to cover part of your college
expenses? Assume no inter-period
compounding. Also, write the spreadsheet
function to display the monthly amount.

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 Example 6
F=80,000
CP=semiannual PP=1month < CP no inter-period interest
1 2 3 years
0
... ... ... ... ...
A

6A 6A 6A 6A 6A 6A
A = F(A/F, effective i% per CP, total number of CPs n)
r = 12% per year, CP=semiannual, m=12/6=2
Effective rate per CP: i = r/m =12%/2 = 6%, n = 3*2 =6 CPs

6A

= PMT(i%,n,P,F)/6= PMT(6%,6,,80000)/6 = -$1911.50

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 Example 7

• 4.53 What nominal rate per quarter is

equivalent to an effective rate of 12.7% per
year, compounded continuously?

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 Example 7

r = nominal rate per year

i = effective rate per year =12.7%

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 Example 8

• 4.60 Brady and Sons borrows $300,000 now at

an interest rate of 12% per year, compounded
monthly, and the rate increases to 15% per
year, compounded monthly after 4 months, how
much will the company owe at the end of year
1?

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 Example 8
P=$300,000 CP=month

4 8 12 months
0
12% per year compounded monthly 15% per year compounded monthly
F = P(F/P, effective i% per CP, total number of CPs n)
F= ?

r1 = 12% per year, CP=month, m1=12/1=12

Effective rate per CP: i1= r1/m1 =12%/12 = 1%
n1 = 4 CPs

r2 = 15% per year, CP=month, m2=12/1=12

Effective rate per CP: i2= r2/m2=15%/12 = 1.25%
n2 = 8 CPs

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Questions?

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