TABLE OF CONTENTS Students often experience problems in solving time-value-of-money problems primarily because they do not know which interest rate to use from among the nominal, effective, and periodic rates. In this paper we show the relationships among different interest rates and clarify the use of these rates in the time-value-of money problems. In particular, we show how to calculate the periodic rate, given the nominal rate, because students must use the periodic rate when they use either the "formula" or "financial calculator" method to compute the interest rate.
Keywords: Annual interest rate; compounding frequency; effective interest rate; nominal interest rate; algebraic method; formula method; financial calculator method.
Students often have problems with different interest rate concepts when confronted with time-value-of-money problems. In particular, they seem to struggle when cash flows do not match compounding periods. For example, suppose one invests $1,000 every six months for the next two years in a bank account that pays 12% interest, compounding quarterly. What will be the future value of this investment in two years? Note that cash flows occur less frequently than compounding periods. In solving the above problem using a formula or financial calculator, students are not sure what interest rate to use that is, 12% annual rate, 6% semi-annual rate, 3% quarterly rate, or something else? This paper addresses this important instructional issue.
In this paper, we first report the results of our investigation...
