In all engineering economy relations developed thus far, the interest rate has
been a constant, annual value. For a substantial percentage of the projects
evaluated by professional engineers in practice, the interest rate is compounded
more frequently than once a year; frequencies such as semiannual,
quarterly, and monthly are common. In fact, weekly, daily, and even continuous
compounding may be experienced in some project evaluations. Also, in
our own personal lives, many of the financial considerations we make—loans
of all types (home mortgages, credit cards, automobiles, boats), checking
and savings accounts, investments, stock option plans, etc.—have interest
rates compounded for a time period shorter than 1 year. This requires the introduction
of two new terms—nominal and effective interest rates.
This chapter explains how to understand and use nominal and effective
interest rates in engineering practice and in daily life situations. The flowchart
on calculating an effective interest rate in the appendix to this chapter
serves as a reference throughout the sections on nominal and effective rates,
as well as continuous compounding of interest. This chapter also develops
equivalence calculations for any compounding frequency in combination
with any cash flow frequency.
The case study includes an evaluation of several financing plans for the
purchase of a house.
