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(c) 2001 Contemporary Engineering Economics 1 Chapter 5 Understanding Money and Its Management Nominal and Effective Interest Rates Equivalence Calculations Changing Interest Rates Debt Management

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(c) 2001 Contemporary Engineering Economics 2 Focus 1. 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?

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(c) 2001 Contemporary Engineering Economics 3 Assumption In chapter 4 our implicit assumptions was that 1.the payment are done annually. 2.Interest rate was also per annum bases Counter examples are common where you can have monthly or quarterly payment / interest period

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(c) 2001 Contemporary Engineering Economics 4 Nominal Versus Effective Interest Rates Nominal Interest Rate : Interest rate quoted based on an annual period Effective Interest Rate : Actual interest earned or paid in a year or some other time period

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(c) 2001 Contemporary Engineering Economics 5 18% Compounded Monthly Nominal interest rate Annual percentage rate (APR) Interest Period / Compounding Frequency

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(c) 2001 Contemporary Engineering Economics 6 Effective Annual Interest Rate r = nominal interest rate per year i a = effective annual interest rate M = number of interest periods per year

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(c) 2001 Contemporary Engineering Economics 7 18% nominal Interest rate compounded monthly Question: Suppose that you invest $1 for 1 year at 18% compounded monthly. How much interest would you earn? Solution: = $1.1956 0.1956 or 19.56% : 1.5% 18%

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(c) 2001 Contemporary Engineering Economics 8 : 1.5% 18% 18% compounded monthly or 1.5% per month for 12 months = 19.56 % compounded annually

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(c) 2001 Contemporary Engineering Economics 9 Effective Annual Interest Rates (9% compounded quarterly) (Ef=0.093) First quarter Base amount + Interest (2.25%) $10,000 + $225 Second quarter = New base amount + Interest (2.25%) = $10,225 +$230.06 Third quarter = New base amount + Interest (2.25%) = $10,455.06 +$235.24 Fourth quarter = New base amount + Interest (2.25 %) = Value after one year = $10,690.30 + $240.53 = $10,930.83

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(c) 2001 Contemporary Engineering Economics 10 Nominal and Effective Interest Rates with Different Compounding Periods (Table 5.1) Effective Rates Nominal Rate APR Compounding Annually Compounding Semi-annually Compounding Quarterly Compounding Monthly Compounding Daily 4%4.00%4.04%4.06%4.07%4.08% 55.005.065.095.125.13 66.006.096.146.176.18 77.007.127.197.237.25 88.008.168.248.308.33 99.009.209.319.389.42 1010.0010.2510.3810.4710.52 1111.0011.3011.4611.5711.62 1212.0012.3612.5512.6812.74

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(c) 2001 Contemporary Engineering Economics 11 Effective Interest Rate per Payment Period (i) C = number of interest periods per payment period K = number of payment periods per year M = CK = The number of interest periods per year

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(c) 2001 Contemporary Engineering Economics 12 12% compounded monthly Payment Period = Quarter Compounding Period = Month One-year Effective interest rate per quarter Effective annual interest rate 1% 3.030 % 1st Qtr2nd Qtr3rd Qtr4th Qtr

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(c) 2001 Contemporary Engineering Economics 13 Effective Interest Rate per Payment Period with Continuous Compounding where CK = number of compounding periods per year continuous compounding =>

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(c) 2001 Contemporary Engineering Economics 14 Case 0: 8% compounded quarterly Payment Period = Quarter Interest Period = Quarterly 1 interest period Given r = 8%, K = 4 payments per year C = 1 interest periods per quarter M = 4 interest periods per year 2 nd Q3 rd Q4 th Q 1 st Q

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(c) 2001 Contemporary Engineering Economics 15 Case 1: 8% compounded monthly Payment Period = Quarter Interest Period = Monthly 3 interest periods Given r = 8%, K = 4 payments per year C = 3 interest periods per quarter M = 12 interest periods per year 2 nd Q3 rd Q4 th Q 1 st Q

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(c) 2001 Contemporary Engineering Economics 16 Case 2: 8% compounded weekly Payment Period = Quarter Interest Period = Weekly 13 interest periods Given r = 8%, K = 4 payments per year M / K=C = 13 interest periods per quarter C x K=M = 52 interest periods per year 2 nd Q3 rd Q4 th Q 1 st Q

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(c) 2001 Contemporary Engineering Economics 17 Case 3: 8% compounded continuously Payment Period = Quarter Interest Period = Continuously interest periods Given r = 8%, K = 4 payments per year 2 nd Q3 rd Q4 th Q 1 st Q

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(c) 2001 Contemporary Engineering Economics 18 Summary: Effective interest rate per quarter Case 0Case 1Case 2Case 3 8% compounded quarterly 8% compounded monthly 8% compounded weekly 8% compounded continuously Payments occur quarterly 2.000% per quarter 2.013% per quarter 2.0186% per quarter 2.0201% per quarter

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(c) 2001 Contemporary Engineering Economics 19 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.

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(c) 2001 Contemporary Engineering Economics 20 Case I: When Payment Periods and Compounding periods coincide (overlap) 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 (number of years) Step 4: Use the appropriate interest formula using i and N above

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(c) 2001 Contemporary Engineering Economics 21 Example 5.5: Calculating Auto Loan Payments Given: Invoice Price = $21,599 Sales tax at 4% = $21,599 (0.04) = $863.96 Dealer’s freight 1%= $21,599 (0.01) = $215.99 Total purchase price = $22,678.95 Down payment = $2,678.95 Dealer’s interest rate = 8.5% APR Length of financing = 48 months Find: the monthly payment

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(c) 2001 Contemporary Engineering Economics 22 Example 5.5: Payment Period = Interest Period Given: P = $20,000, r = 8.5% per year K = 12 payments per year N = 48 payment periods Find A Step 1: M = 12 (number of compounding periods per year) Step 2: i = r/M = 8.5%/12 = 0.7083% per month Step 3: N = M x (# of years) = (12)(4) = 48 months Step 4: A = $20,000(A/P, 0.7083%,48) = $492.97 48 0 1 2 3 4 $20,000 A

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(c) 2001 Contemporary Engineering Economics 23 Case II: When Payment Periods Differ from Compounding Periods Step 1: Identify the following parameters M = No. of compounding periods K = No. of payment C = No. of interest periods per payment period Step 2: Compute the effective interest rate per payment period For discrete compounding For continuous compounding Step 3: Find the total no. of payment periods N = K (no. of years) Step 4: Use i and N in the appropriate equivalence formula

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(c) 2001 Contemporary Engineering Economics 24 Discrete Case: Quarterly deposits with Monthly compounding (Example 5.6) Step 1: M = 12 compounding periods/year K = 4 payment periods/year C = 3 interest periods per quarter Step 2: Step 3: N = 4(3) = 12 quarters Step 4: F = $1,000 (F/A, 3.030%, 12) = $14,216.24 F = ? A = $1,000 0 1 2 3 4 5 6 7 8 9 10 11 12 Quarters Year 1Year 2Year 3

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(c) 2001 Contemporary Engineering Economics 25 Continuous Case: Quarterly deposits with Continuous compounding Step 1: K = 4 payment periods/year C = interest periods per quarter Step 2: Step 3: N = 4(3) = 12 Step 4: F = $1,000 (F/A, 3.045%, 12) = $14,228.37 F = ? A = $1,000 0 1 2 3 4 5 6 7 8 9 10 11 12 Quarters Year 2Year 1Year 3

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(c) 2001 Contemporary Engineering Economics 26 Commercial Loans (5.6.2-206) Amortized (equal payment) Loans (Example 5.13 & 5.14) Effective interest rate specified Paid off in installments over time Equal periodic amounts (monthly or quarterly etc) (amortized) Examples: Auto-loans, home mortgage loans, most business loans

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(c) 2001 Contemporary Engineering Economics 27 Example 5.13 Loan Repayment Schedule $5,000 A = $235.37 0 1 2 3 4 5 6 7 22 23 24 i = 1% per month

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(c) 2001 Contemporary Engineering Economics 28 Practice Problem Consider the 7 th payment ($235.37) (a) How much is the interest payment? (b) What is the amount of principal payment?

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(c) 2001 Contemporary Engineering Economics 29 Solution $5,000 A = $235.37 0 1 2 3 4 5 6 7 22 23 24 i = 1% per month Interest payment = ? Principal payment = ?

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(c) 2001 Contemporary Engineering Economics 30 Solution

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(c) 2001 Contemporary Engineering Economics 31

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(c) 2001 Contemporary Engineering Economics 32 Amortized Loan - Auto Loan $20,000 0 48 122524 Given: APR = 8.5%, N = 48 months, and P = $20,000 Find: A A = $20,000(A/P,8.5%/12,48) = $492.97

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(c) 2001 Contemporary Engineering Economics 33 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 0 48 122524 $492.97 23 payments that are still outstanding 25 payments that were already made P = $492.97 (P/A, 0.7083%, 23) = $10,428.96 ( instead $11338.31 )

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(c) 2001 Contemporary Engineering Economics 34 Summary Financial institutions often quote interest rate based on an APR. 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 interest period differ, calculate an effective interest rate that covers the payment period.

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