Recall: PP Is Now Introduced: Why "CP" and "PP"?

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
4.3 Payment Period (PP)
Recall:
 CP is the “compounding period”
PP is now introduced:
 PP is the “payment period”
Why “CP” and “PP”?
 Often the frequency of depositing funds or
making payments does not coincide with
the frequency of compounding.
303: Chapter 3: DRSBlank & Tarquin: 5th Edition. Ch 4 Authored by Dr. Don Smith, Texas A&M University 1
Example 4.4
Three vendor bids are as given below;

Payments will be made semi-annually.
1. 9% per year, c.q. (compounded

quarterly).
2. 3% per quarter, compounded quarterly.
3. 8.8% per year, c.m. (compounded
monthly)
Which Plan has the lowest annual interest rate?
4.3 Comparing 3 Plans: Plan 1
9% per year, c.q.

Payments made every 6 months.
0 CP-1 CP-2 CP-3 CP-4 1
Payment Period 1 Payment Period 2
Payment Payment
9%, c.q. = 0.09/4 = 0.0225 per 3 months = 2.25% per 3

months
4.3 The Matching Rule
Again, the interest must be consistent

with the payment period!
We need a 6-month effective rate and
then calculate the 1 year true, effective
rate!
To compare the 3 plans:
 Compute the true, effective 6-month rate or,
 Compute the true effective 1 year rate.
 Then one can compare the 3 plans!
4.3 Comparing 3 Plans: Plan 1
9% per year, c.q. = 2.25%/quarter

Payments made every 6 months.
0 CP-1 CP-2 CP-3 CP-4 1
Payment Period 1 Payment Period 2
Payment Payment
True 6-month rate is: (Since there are 2 quarters in 6

months
(1.0225)2 – 1 = 0.0455 = 4.55% per 6-months
EAIR = (1.0225)4 – 1 = 9.31% per year

4.3 Plan 2
3% per quarter, c.q.

3%/quarter
Find the EIR for 6-months
Calculate:
 For a 6-month effective interest rate -
 (1.03)2 – 1 = 0.0609 = 6.09% per 6-months
 Or, for a 1 year effective interest rate -
 (1.03)4 – 1 = 12.55%/year
4.3 Plan 3:” 8.8% per year, c.m.”
“r” = 8.8%
“m” = 12
Payments are twice a year
6-month nominal rate = 0.088/2
=4.4%/6-months (“r” = 0.044)
EIR6-months = (1 + 0.044/6)6 – 1
 Equals (1.0073)6 – 1= 4.48%/ 6-months
 Equals (1 + 0.088/12)12 – 1 = 9.16%/year
4.3 Summarizing the 3 plans….
Plan No. 6-month 1-year

1 4.55% 9.31%
2 6.09% 12.55%
3 4.48% 9.16%
Plan 3 presents the lowest interest rate.
ENGINEERING ECONOMY Fifth Edition

Mc
Blank and Tarquin Graw
Hill
Chapter IV
4. Equivalence Relations:
Comparing Payment Period and
Compounding Period Lengths
(PP vs. CP)

Mc
Hill
Chapter IV
5. Equivalence Relations: Single

Amounts with PP >= CP
4.5 Single Amounts: CP >= CP
Example:
“r” = 15%, c.m. (compounded monthly)
Let P = $1500.00
Find F at t = 2 years.
15% c.m. = 0.15/12 = 0.0125 =
1.25%/month.
n = 2 years OR 24 months
Work in months or in years
4.5 Single Amounts: PP >= CP
Approach 1. (n relates to months)

State:
 F24 = $1,500(F/P,0.15/12,24);
 i/month = 0.15/12 = 0.0125 (1.25%);
 F24 = $1,500(F/P,1.25%,24);
 F24 = $1,500(1.0125)24 = $1,500(1.3474);
 F24 = $2,021.03.
4.5 Single Amounts: PP >= CP
Approach 2. (n relates to years)

State:
 F24 = $1,500(F/P,i%,2);
 Assume n = 2 (years) we need to apply an
annual effective interest rate.
 i/month =0.0125
 EAIR = (1.0125)12 – 1 = 0.1608 (16.08%)
 F2 = $1,500(F/P,16.08%,2)
 F2 = $1,500(1.1608)2 = $2,021.19
 Slight roundoff compared to approach 1
4.5 Example 2.
F 10 = ?
Consider
r = 12%/yr, c.s.a.
0 1 2 3 4 5 6 7 8 9 10
$1,000 $1,500
$3,000
Suggest you work this in 6 - month time frames

Count “n” in terms of “6-month” intervals
4.5 Example 2.
F 20 = ?
Renumber the time line
r = 12%/yr, c.s.a.
0 2 4 6 8 10 12 14 16 18 20
$1,000 $1,500
$3,000
i/6 months = 0.12/2 = 6%/6 months; n counts 6-

month time periods
4.5 Example 2.
F 20 = ?
Compound Forward
r = 12%/yr, c.s.a.
0 2 4 6 8 10 12 14 16 18 20
$1,000 $1,500
$3,000
F20 = $1,000(F/P,6%,20) + $3,000(F/P,6%,12) +
$1,500(F/P,6%,8) = $11,634
4.5 Example 2. Let n count years….

F 10 = ?
Compound Forward
r = 12%/yr, c.s.a.
0 1 2 3 4 5 6 7 8 9 10
$1,000 $1,500
$3,000
IF n counts years, EAIR = (1.06)2 - 1 = 12.36%
F10 = $1,000(F/P,12.36%,10) + $3,000(F/P,12.36%,6)

+ $1,500(F/P,12.36%,4) = $11,634

Mc
Hill
Chapter IV
6. Equivalence Relations: Series

with PP >= CP
4.6 Series Analysis – PP >= CP
Find the effective “i” per payment period.

Determine “n” as the total number of
payment periods.
“n” will equal the number of cash flow
periods in the particular series.
Example follows…..
Example
For the past 7 years, a manager

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 20 % per
year, compounded quarterly.
4.6 Series Example F7 = ??
Consider:
0 1 2 3 4 5 6 7
A = $500 every 6 months
Find F7 if “r” = 20%/yr, c.q. (PP > CP)

We need i per 6-months – effective.
i6-months = adjusting the nominal rate to fit.
4.6 Series Example
Adjusting the interest

r = 20%, c.q.
i/qtr. = 0.20/4 = 0.05 = 5%/qtr.
2-qtrs in a 6-month period.
i6-months = (1.05)2 – 1 = 10.25%/6-months.
Now, the interest matches the payments.
Fyear 7 = Fperiod 14 = $500(F/A,10.25%,14)
F = $500(28.4891) = $14,244.50
4.6 This Example: Observations
Interest rate must match the frequency of the

payments.
In this example – we need effective interest
per 6-months: Payments are every 6-months.
The effective 6-month rate computed to equal
10.25% - un-tabulated rate.
Calculate the F/A factor or interpolate.
Or, use a spreadsheet that can quickly
determine the correct factor!
4.6 This Example: Observations
Do not attempt to adjust the payments to fit

the interest rate!
This is Wrong!
At best a gross approximation – do not do it!
This type of problem almost always results in
an un-tabulated interest rate
 You have to use your calculator to compute
the factor or a spreadsheet model to achieve
exact result.

Mc
Hill
Chapter IV
7. Equivalence Relations: Single

Amounts and Series with PP < CP
4.7 Single Amounts/Series with PP < CP
This situation is different than the last.

Here, PP is less than the compounding period
(CP).
Raises questions?
Issue of interperiod compounding
Interperiod CFs earn no interest or they earn
Compound interest
An example follows.
4.7 Interperiod Compounding Issues
Consider a one-year cash flow situation.

Payments are made at end of a given month.
Interest rate is “r = 12%/yr, c.q.”
$120
$90
$45
0 1 2 3 4 5 6 7 8 9 10 11
12
$75 $50
$150 $100
$200
4.7 Interperiod Compounding
r =12%/yr. c.q.
$120
$90
$45
CP-1 CP-2 CP-3 CP-4
0 1 2 3 4 5 6 7 8 9 10 11
12
$75 $50
$150 $100
$200
Note where some of the cash flow amounts fall with

respect to the compounding periods!
4.7 Take the first $200 cash flow
Will any interest be earned/owed on the $200 since

interest is compounded at the end of each quarter?
$120
$90
$45
CP-1
The $200 is at the end of
0 1 2 3 4 5 6 7 8 9 10 11
12 month 2 and will it earn
$150 $75interest
$100 for one month $50to go
to the end of the first

$200
compounding period?
The last month of the first compounding period.
Is this an interest-earning period?
4.7 Interperiod Issues
The $200 occurs 1 month before the end of

compounding period 1.
Will interest be earned or charged on that
$200 for the one month?
If not then the revised cash flow diagram for
all of the cash flows should look like…..
4.7 No interperiod compounding

$165
Revised CF Diagram
$90 $90
$45
0 1 2 3 4 5 6 7 8 9 10 11
12
$75 $50 $50
$150 $100
$200 $200
$175
All negative CF’s move to the end of their respective

quarters and all positive CF’s move to the beginning
of their respective quarters.
4.7 No interperiod compounding

$165
Revised CF Diagram
$90
0 1 2 3 4 5 6 7 8 9 10 11
12
$150 $50
$175
$200
Now, determine the future worth of this revised series

using the F/P factor on each cash flow.
4.7 Final Results: No interperiod Comp.
With the revised CF compute the future

worth.
“r” = 12%/year, compounded quarterly
“i” = 0.12/4 = 0.03 = 3% per quarter
F12 = [-150(F/P3%,4) – 200(F/P,3%,3) + (-175 +90)

(F/P,3%,2) + 165(F/P,3%,1) – 50]
= $-357.59

Recall: PP Is Now Introduced: Why "CP" and "PP"?

Uploaded by

Copyright:

Available Formats

Recall: PP Is Now Introduced: Why "CP" and "PP"?

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Recall: PP Is Now Introduced: Why "CP" and "PP"?

Uploaded by

Copyright:

Available Formats

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

4.3 Payment Period (PP)

Three vendor bids are as given below;

1. 9% per year, c.q. (compounded

4.3 Comparing 3 Plans: Plan 1

9% per year, c.q.

0 CP-1 CP-2 CP-3 CP-4 1

Payment Period 1 Payment Period 2

9%, c.q. = 0.09/4 = 0.0225 per 3 months = 2.25% per 3

4.3 The Matching Rule

Again, the interest must be consistent

4.3 Comparing 3 Plans: Plan 1

9% per year, c.q. = 2.25%/quarter

0 CP-1 CP-2 CP-3 CP-4 1

Payment Period 1 Payment Period 2

True 6-month rate is: (Since there are 2 quarters in 6

(1.0225)2 – 1 = 0.0455 = 4.55% per 6-months

EAIR = (1.0225)4 – 1 = 9.31% per year

3% per quarter, c.q.

4.3 Plan 3:” 8.8% per year, c.m.”

4.3 Summarizing the 3 plans….

Plan No. 6-month 1-year

Plan 3 presents the lowest interest rate.

ENGINEERING ECONOMY Fifth Edition

ENGINEERING ECONOMY Fifth Edition

5. Equivalence Relations: Single

4.5 Single Amounts: CP >= CP

4.5 Single Amounts: PP >= CP

Approach 1. (n relates to months)

4.5 Single Amounts: PP >= CP

Approach 2. (n relates to years)

Suggest you work this in 6 - month time frames

i/6 months = 0.12/2 = 6%/6 months; n counts 6-

F20 = $1,000(F/P,6%,20) + $3,000(F/P,6%,12) +

4.5 Example 2. Let n count years….

F10 = $1,000(F/P,12.36%,10) + $3,000(F/P,12.36%,6)

ENGINEERING ECONOMY Fifth Edition

6. Equivalence Relations: Series

4.6 Series Analysis – PP >= CP

Find the effective “i” per payment period.

For the past 7 years, a manager

4.6 Series Example F7 = ??

A = $500 every 6 months

Find F7 if “r” = 20%/yr, c.q. (PP > CP)

4.6 Series Example

Adjusting the interest

4.6 This Example: Observations

Interest rate must match the frequency of the

4.6 This Example: Observations

Do not attempt to adjust the payments to fit

ENGINEERING ECONOMY Fifth Edition

7. Equivalence Relations: Single

4.7 Single Amounts/Series with PP < CP

This situation is different than the last.

4.7 Interperiod Compounding Issues

Consider a one-year cash flow situation.

4.7 Interperiod Compounding

Note where some of the cash flow amounts fall with

4.7 Take the first $200 cash flow