How do I convert a quoted annual rate into the rate I should use in a TVM problem?
I get confused when a problem gives a stated annual rate but the payments are monthly or quarterly. Should I divide the rate, calculate an effective annual rate, or do both?
First match the rate to the cash-flow period. If the cash flows are monthly, use a monthly periodic rate. If you need an annual return measure, convert to an effective annual rate.
For a stated annual rate of 8 percent compounded monthly:
Monthly rate = 0.08 / 12 = 0.006667
EAR = (1 + 0.08 / 12)^12 - 1 = 8.30%
Use 0.6667 percent per month to value monthly payments. Use 8.30 percent to compare annual effective returns. The most common error is discounting monthly cash flows with the annual stated rate or discounting annual cash flows with the monthly periodic rate.
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