Chapter 8: Time Value of Money 255

Hence, 12.68% compounded annually is effectively equal to 12% compounded monthly.

What are the EARs for semiannual and quarterly compounding at 12%?
Provinces and territories have regulations imposing controls on advertising the cost of bor-
rowing. Most of these regulations require that an annual percentage rate be quoted, according
to some prescribed mathematical formula. Watch for it the next time you see an advertisement
for a bank.
In general, the EAR can be calculated for any compounding period by using the following
formula.


k m
(8.15) EAR
1  nom
 –1
m
where m is the number of compounding periods per year (12 for monthly, 4 for quarterly, and
2 for semiannually).
The effect of more frequent compounding is greater at higher interest rates. Table 8.3 illus-
trates this point. At a nominal rate of 6%, the effective increase in interest due to monthly rather
than annual compounding is only 0.17%, which represents a 2.8% increase in the rate actually
paid (0.17%/6.00%
0.028
2.8%). At 18%, however, the effective increase is 1.56%, which
represents an 8.7% increase in what’s actually paid.

The APR and the EAR

Credit card companies charge monthly interest on unpaid balances at rates in the neighbourhood
■ The annual per-
of 1.5%. This represents a monthly compounding of interest on the cardholder’s debt. They
centage rate (APR)
advertise that the annual percentage rate, known as the APR, is 18%, 12 times the monthly rate. associated with credit
Don’t confuse the APR with the EAR. The APR is actually the nominal rate. Table 8.3 shows cards is actually the
that, at a nominal rate of 18%, the EAR for monthly compounding is 19.56%, somewhat more nominal rate and is less
than 18%.6 than the EAR.

Compounding Periods and the Time Value Formulas

Each of the time value formulas contains an interest rate, k, and a number of time periods or
payments, n. In using the formulas, the time periods must be compounding periods, and the
interest rate must be the rate for a single compounding period.
The problems we’ve dealt with so far have all involved annual compounding. In that case,
the compounding period is a year, and the appropriate interest rate is the nominal rate itself.
Things are a little more complicated with non-annual compounding periods. Let’s consider
quarters as an example.
Suppose we have a time value problem that runs for five years and has an interest rate of
12%. If compounding is annual, k and n are simply 12 and 5, respectively. However, if com-
pounding is quarterly, the appropriate period is one quarter and the rate for that period is
(12%/4 =) 3%. Further, the time dimension of the problem needs to be stated as 20 quarters
rather than five years (5 years  4 quarters/year
20 quarters). Hence k and n for the problem
should be 3 and 20, respectively.

TABLE 8.3
Nominal EAR for Monthly Effective Increase as Changes in the
Rate Compounding Increase % of knom Effect of
6% 6.17% 0.17% 2.8% Compounding at
12 12.68 0.68 5.7
Different Rates
18 19.56 1.56 8.7

6 For those students who worked through Chapter 5, this discussion might sound familiar. On
pages 145–146 we discussed the cost of forgoing an early payment discount. The APR was 37.2%
and the EAR was 44.6%.

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 Chapter 8: Time Value of Money 257

schooling. They’re now searching for an investment vehicle that will provide a return
sufficient to grow these savings into $50,000 in four years. If quarterly compounding is
assumed, how large a return (interest rate) do the Johnsons have to get to achieve their
goal? Is it realistic?

■ Solution: Once again we recognize this as a future value of an annuity problem

because of the stream of payments involved and the fact that the Johnsons are saving for
a known future amount.
Because the problem runs for four years and the compounding along with the pay-
ments is quarterly, n is calculated as

n
4 years  4 quarterly payments/year
16 quarterly payments

Equation 8.14 gives the future value of an annuity expression.

FVAn
PMT[FVFAk,n]

Substituting values from the problems, we have

$50,000
$2,250[FVFAk,16]

Solving for the factor yields

FVFAk,16
22.2222
CALCULATOR
In Appendix A–3 we search for this value along the row for 16 payments and find that it
SOLUTION
lies between 4% and 4.5%. In this case it’s fairly easy to estimate that the factor is about
half of the way between 4% and 4.5%. Key Input
Hence, the approximate solution is 4.2%; however, that’s a quarterly rate. The appro- n 16
priate nominal rate is PMT 2,250
FV 50,000
4.2%  4
16.8% PV 0
This is a high rate of return to expect on invested money. Is it reasonable to expect such a Answer
rate to be sustained over four years? I/Y 4.2
There’s no definite answer to that question. There have been times when that expec-
tation would have been reasonable, but such a high rate can always be expected to involve
substantial risk. Because they probably don’t want to risk not being able to send Molly to
college, the Johnsons should probably try to save a little more and opt for a more conser-
vative investment.

Dealing with Differences in Compounding and Payment Frequencies

Converting n and k to like terms works well when the interest compounding occurs with the
same frequency as the payments. However, in some cases these frequencies do not correspond;
that is, the compounding occurs more or less often than the payments. In such cases, we must
calculate an appropriate k—one that matches the payment cycle.
Using our Example 8.8, let’s assume that the Johnsons wanted to save $750 per month over the
next four years but the investment vehicle they are considering pay 6% per annum and compounds
the interest semiannually. How much will the Johnsons have accumulated at the end of four years?

SOLUTION: Now we have payments occurring monthly and interest compounded semiannu-
ally. The interest and payment cycle must be in like terms, and it is the payment frequency that
dictates how k will be handled! So to get the proper k, we must make a few adjustments to our
Equation 8.15.


k m
(8.15) EAR
1  nom
 –1
m

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258 Part 3: Capital Markets and Securities

We will call the appropriate k (that is, the one that matches our payment cycle) k*. With a
little algebra, Equation 8.15 becomes:


k m
n –
8.16 k*
1  nom
 1
m
where m is the number of times during the period that interest is compounded and n is the
number of payments to be made during that period.
So for our problem k* is:

 1
2
0.06 
k*
1   12
2

1  0.03  1
1

6

= 0.004939 or 0.4939% per month

CALCULATOR
And n, the number of payments to be made, is 4  12
48. As the interest rate is not on
SOLUTION
the tables, we need to use Equation 8.13 on page 249 to solve the problem.
Key Input
750[(1  0.004939)48 – 1]
n 48 FVAn

PMT 750 0.004939
PV 0
$40,513
I/Y .4939

Answer Let’s look at another situation with the Johnsons. Say they decided to make quarterly pay-
ments of $2,250, but the investment vehicle paid 6% per annum, compounded monthly. How
FV 40,513
much would they have saved by the end of the fourth year?
SOLUTION: Again, the payments occur less frequently than the interest is compounded. To get
the proper k, we use our Equation 8.16, where m is the number of times during the period that
interest is compounded and n is the number of payments to be made during that period.
So for our problem k* is:
k


m

k*
1  nmom
 n –1


12
0.06 
= 1   4 –1
12
CALCULATOR
SOLUTION = (1  0.005)3 – 1
Key Input = 0.01508 or 1.508% per quarter
n 16
PMT 2,250 And n, the number of payments to be made, is 4  4
16. As the interest rate is not on
I/Y 1.508 the tables, we need to use Equation 8.13 on page 249 to solve the problem.
PV 0
2250[(1  0.01508)16 – 1]
Answer FVAn

0.01508
FV 40,373

$40,373

The Present Value of an Annuity—Developing a Formula

The present value of an annuity is simply the sum of the present values of all of the annuity’s
payments. We could always calculate these individually, but it’s much easier to develop a

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