Are effective rates like the effective periodic rate (EPR) or effective annual rate (EAR) actually used for, say, discounting cash flows or are these merely rates that have been transformed so that one can compare rates with different compounding periods (monthly, quarterly, etc) and to know actually what you are paying/receiving as a result of compounding ??
I realize the effective periodic rate of 15% annually with semiannual compounding is approx 7.238%, not 7.5%. But if you were running a DCF with semiannual cash flows, which rate would you use to discount the semiannual cash flows ??
I’ve always thought when using a non-annual compounding rate the present value factor would be, in this case:
1 / (1+r/2)^(t*2) = 1 / (1.075)^(t*2) = .930232 if at the end of year 1
but if you use the 7.238% you get a different PV factor (.9325)…so which is it ?
I’ve always thought to capture different compounding, you just divide the annual rate by the compounding period and multiply the time (t) by the compounding periods. Especially for bonds, don’t we just divide the rate by the compounding periods??
Thanks in advance!