Interest Rates

Chapter 5
Interest Rates
Chapter Outline
5.1 Interest Rate Quotes and Adjustments
5.2 Application: Discount Rates and Loans
5.3 The Determinants of Interest Rates
5.4 Risk and Taxes
5.5 The Opportunity Cost of Capital
Copyright 2014 Pearson Education, Inc. All rights reserved.
5-2
Learning Objectives
1. Define effective annual rate and annual
percentage rate.
2. Given an effective annual rate, compute
the n-period effective annual rate.
3. Convert an annual percentage rate into an
effective annual rate, given the number of
compounding periods.
4. Describe the relation between nominal and
real rates of interest.
5-3
Learning Objectives
5. Given two of the following, compute the
third: nominal rate, real rate, and inflation
rate.
6. Describe the effect of higher interest rates
on net present values in the economy.
7. Explain how to choose the appropriate
discount rate for a given stream of cash
flows, according to the investment
horizon.
5-4
Learning Objectives (cont'd)

8. Discuss the determinants of the shape of
the yield curve.
9. Explain why Treasury securities are
considered risk free, and describe the
impact of default risk on interest rates.
10.Given the other two, compute the third:
after-tax interest rate, tax rate, and
before-tax interest rate.
5-5
5.1 Interest Rate Quotes and

Adjustments
The Effective Annual Rate
Indicates the total amount of interest that will
be earned at the end of one year
Considers the effect of compounding
Also referred to as the effective annual yield (EAY) or
annual percentage yield (APY)
5-6
5.1 Interest Rate Quotes

and Adjustments (cont'd)
Adjusting the Discount Rate to Different
Time Periods
Earning a 5% return annually is not the same

as earning 2.5% every six months.
(1+2.5%)2 = 1.05063
(1+5%)0.5 =1.0247
General Equation for Discount Rate Period

Conversion
Equivalent n-Period Discount Rate (1 r ) n 1
5-7
Textbook Example 5.1
5-8
Textbook Example 5.1 (cont'd)
5-9
Alternative Example 5.1

Problem
Suppose an investment pays interest quarterly
with the interest rate quoted as an effective
annual rate (EAR) of 9%.
What amount of interest will you earn each quarter?
If you have no money in the bank today, how

much will you need to save at the end of each
quarter to accumulate $25,000 in 5 years?
5-10

Solution
From Equation 5.1, a 9% EAR is approximately
equivalent to earning (1.09)1/4 1 = 2.1778%
per quarter.
To determine the amount to save each quarter
to reach the goal of $25,000 in five years, we
must determine the quarterly payment, C:
C
FV ( Annuity )
$25, 000
$1, 010.82 per quarter

1
1
n
[(1 r ) 1]
[1.02177820 1]
r
.021778
5-11
Annual Percentage Rates

The annual percentage rate (APR),
indicates the amount of simple interest
earned in one year.
Simple interest is the amount of interest
earned without the effect of compounding.
The APR is typically less than the effective
annual rate (EAR).
5-12

(cont'd)
The APR itself cannot be used as a discount
rate.
The APR with k compounding periods is a way
of quoting the actual interest earned each
compounding period:
APR
Interest Rate per Compounding Period
k periods / year
5-13

(cont'd)
Converting an APR to an EAR
APR
1 EAR 1
The EAR increases with the frequency of

compounding.
5-14

(cont'd)
Table 5.1 Effective Annual Rates for a 6% APR with
Different Compounding Periods
5-15
5-16
Textbook
Example
5.2
(cont'd)
5-17

Problem
A firm is considering purchasing or leasing a
luxury automobile for the CEO. The vehicle is
expected to last 3 years. You can buy the car
for $65,000 up front , or you can lease it for
$1,800 per month for 36 months. The firm can
borrow at an interest rate of 8% APR with
quarterly compounding. Should you purchase
the system outright or pay $1,800 per month?
5-18
Alternative Example 5.2 (contd)

Solution
The first step is to compute the discount rate
that corresponds to monthly compounding. To
convert an 8% rate compounded quarterly to a
monthly discount rate, compound the quarterly
rate using Equations 5.3 and 5.1:
1
.08 4
(1
) 1.082432 1.08243212 1 0.66227% per month
4
5-19

Solution
Given a monthly discount rate of 0.66227%, the
present value of the 36 monthly payments can
be computed:
1
1
PV $1,800
1
$57, 486
36
0.0066227 1.0066227
Paying $1,800 per month for 36 months is
equivalent to paying $57,486 today. This is
$65,000 - $57,486 = $7,514 lower than the cost
of purchasing the system, so it is better to lease
the vehicle rather than buy it.
5-20
5.2 Application: Discount Rates

and Loans
Computing Loan Payments
Payments are made at a set interval, typically
monthly.
Each payment made includes the interest on the
loan plus some part of the loan balance.
All payments are equal and the loan is fully
repaid with the final payment.
5-21

and Loans (cont'd)
Computing Loan Payments
Consider a $30,000 car loan with 60 equal
monthly payments, computed using a 6.75%
APR with monthly compounding.
6.75% APR with monthly compounding corresponds to
a one-month discount rate of 6.75% / 12 = 0.5625%.
C
1
1
1
(1 r ) N
r
30, 000
1
1
1
0.005625
(1 0.005625)60
$590.50
5-22

and Loans (cont'd)
Computing the Outstanding Loan Balance
One can compute the outstanding loan balance
by calculating the present value of the
remaining loan payments.
5-23
5-24
5-25
5.3 The Determinants of Interest

Rates
Inflation and Real Versus Nominal Rates
Nominal Interest Rate: The rates quoted by
financial institutions and used for discounting or
compounding cash flows
Real Interest Rate: The rate of growth of your
purchasing power, after adjusting for inflation
5-26
5.3 The Determinants

of Interest Rates (cont'd)
1 r
Growth of Money
Growth in Purchasing Power 1 rr

1 i
Growth of Prices
The Real Interest Rate

rr
r i
r i
1 i
5-27
5-28

rr
r i
r i
1 i
5-29

Problem
In the year 2008, the average 1-year Treasury
Constant Maturity rate was about 1.82% and
the rate of inflation was about 0.28%.
What was the real interest rate in 2008?
5-30

Solution
r i
rr
r i
1 i
Using Equation 5.5, the real interest rate in

2008 was:
(1.82% 0.28%) (1.0028) = 1.54%
Which is (approximately) equal to the difference between
the nominal rate and inflation: 1.82% 0.28% = 1.54%
5-31
Figure 5.1 U.S. Interest Rates

and Inflation Rates,19602012
5-32
Investment and Interest Rate

Policy
An increase in interest rates will typically
reduce the NPV of an investment.
Consider an investment that requires an initial
investment of $10 million and generates a cash
flow of $3 million per year for four years. If the
interest rate is 5%, the investment has an NPV
of:
3
3
3
3
NPV 10
$0.638 million
2
3
4
1.05
1.05
1.05
1.05
5-33
Investment and Interest Rate

Policy (cont'd)
If the interest rate rises to 9%, the NPV
becomes negative and the investment is no
longer profitable:
NPV 10
3
3
3
3
$0.281 million
2
3
4
1.09
1.09
1.09
1.09
5-34
Monetary Policy, Deflation, and

the 2008 Financial Crisis
When the 2008 financial crisis struck, the
Federal Reserve responded by cutting its
short-term interest rate target to 0%.
While this use of monetary policy is
generally quite effective, because consumer
prices were falling in late 2008, the inflation
rate was negative, and so even with a 0%
nominal interest rate the real interest rate
remained positive.
5-35
The Yield Curve and Discount

Rates
Term Structure: The relationship between
the investment term and the interest rate
Yield Curve: A graph of the term structure
5-36
Figure 5.2 Term Structure of Risk-Free U.S.

Interest Rates, November 2006, 2007, and 2008
5-37
The Yield Curve

and Discount Rates (cont'd)
The term structure can be used to compute
the present and future values of a risk-free
cash flow over different investment
horizons.
Cn
PV
(1 rn ) n
Present Value of a Cash Flow Stream Using a

Term Structure of Discount Rates
CN
C1
C2
PV
N
2
1 r1
(1 r2 )
(1 rN )
n 1
CN
(1 rn ) n
5-38
5-39
5-40

Problem
Compute the present value of a risk-free
three-year annuity of $500 per year, given
the following yield curve:
Treasury Rates
Term (Years)
Rate
1
0.261%
2
0.723%
3
1.244%
5-41

Solution
Each cash flow must be discounted by the
corresponding interest rate:
$500
$500
$500
PV
2
1.00261 1.00723 1.012443
PV $498.70 $492.85 481.79 $1, 473.34
5-42
5-43
5-44

Problem
Suppose the current one-year interest rate is
3%. If it is known with certainty that the oneyear interest rate will be 2% next year and 1%
the following year, what will the interest rates r1,
r2, and r3 of the yield curve be today? Is the yield
curve flat, increasing, or inverted?
5-45

Solution
We are told already that the one-year rate r1 =
3%.
To find r2, we know that if we invest $1 for one
year at the current one-year rate and then
reinvest next year at the new one-year rate,
after two years we will earn:
$1 * (1.03) * (1.02) = $1.0506
5-46

Solution
We should earn the same payoff if we invest for
two years at the current two-year rate r2:
$1 * (1 + r2)2 = $1.0506
Otherwise, there would be an arbitrage
opportunity
Solving for r2, we find that:
r2 = (1.0506)1/2 - 1 = 2.499%
5-47

Solution
Similarly, investing for three years at the oneyear rates should have the same payoff as
investing at the current three-year rate:
(1.03) * (1.02) * (1.01) = 1.0611 = (1 + r3)3
We can solve for
r3 = (1.0611)1/3 - 1 = 1.997%.
Therefore, the current yield curve has r1 = 3%,
r2 = 2.499%, and r3 = 1.997%.
The yield curve is decreasing as a result of the
anticipated lower interest rates in the future.
5-48
5.4 Risk and Taxes

Risk and Interest Rates
U.S. Treasury securities are considered riskfree. All other borrowers have some risk of
default, so investors require a higher rate of
return.
5-49
Figure 5.4 Interest Rates on FiveYear Loans for Various Borrowers, July 2012
Source:
FINRA.org.
5-50
5-51
5-52
After-Tax Interest Rates

Taxes reduce the amount of interest an
investor can keep, and we refer to this
reduced amount as the after-tax interest
rate.
r ( r ) r 1
5-53
5-54
5-55
Chapter 5
Appendix
Continuous Rates and Cash Flows

Discount Rate of a Continuously
Compounded APR
Some investments compound more frequently
than daily.
As we move from daily to hourly to compounding every
second, we approach the limit of continuous
compounding, in which we compound every instant.
The EAR for a Continuously Compounded APR
(1 EAR) e
APR
5-57

(contd)
Discount Rate of a Continuously
Compounded APR
Alternatively, if we know the EAR and want to
find the corresponding continuously
compounded APR, the formula is:
The Continuously Compounded APR for an EAR
APR ln(1 EAR)

Continuously compounded rates are not often used in
practice.
5-58

(contd)
Continuously Arriving Cash Flows
Consider the cash flows of an online book
retailer. Suppose the firm forecasts cash flows of
$10 million per year. The $10 million will be
received throughout each year, not at year-end,
that is, the $10 million is paid continuously
throughout the year.
We can compute the present value of cash flows
that arrive continuously using a version of the
growing perpetuity formula.
5-59

(contd)
If cash flows arrive, starting immediately, at an initial rate
of $C per year, and if the cash flows grow at rate g per
year, then given a discount rate of r per year, the present
value of the cash flows is:
Present Value of a Continuously Growing Perpetuity
C
PV
rcc g cc
where rcc=ln(1+r) and gcc = ln(1+g) are the discount and
growth rates expressed as continuously APRs,
respectively.
5-60

(contd)
The present value of a continuously growing
perpetuity can be approximated by:
C1
C
PV
(1 r )1/2
rcc gcc r g
where C1 is the total cash received during the
first year.
5-61
Textbook Example 5A.1
5-62
Textbook Example 5A.1
5-63

Interest Rates

Загружено:

Сведения о документе

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Interest Rates

Загружено:

Авторское право:

Доступные форматы

Chapter 5

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Learning Objectives (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

5.1 Interest Rate Quotes and

Copyright 2014 Pearson Education, Inc. All rights reserved.

5.1 Interest Rate Quotes

Earning a 5% return annually is not the same

General Equation for Discount Rate Period

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 5.1

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 5.1 (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 5.1

If you have no money in the bank today, how

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 5.1

$1, 010.82 per quarter

Copyright 2014 Pearson Education, Inc. All rights reserved.

Annual Percentage Rates

Copyright 2014 Pearson Education, Inc. All rights reserved.

Annual Percentage Rates

Copyright 2014 Pearson Education, Inc. All rights reserved.

Annual Percentage Rates

The EAR increases with the frequency of

Copyright 2014 Pearson Education, Inc. All rights reserved.

Annual Percentage Rates

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 5.2

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 5.2

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 5.2 (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 5.2 (contd)

5.2 Application: Discount Rates

Copyright 2014 Pearson Education, Inc. All rights reserved.

5.2 Application: Discount Rates

Copyright 2014 Pearson Education, Inc. All rights reserved.

5.2 Application: Discount Rates

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 5.3

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 5.3 (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

5.3 The Determinants of Interest

Copyright 2014 Pearson Education, Inc. All rights reserved.

5.3 The Determinants

Growth in Purchasing Power 1 rr

The Real Interest Rate

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 5.4

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 5.4 (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 5.4

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 5.4

Using Equation 5.5, the real interest rate in

Copyright 2014 Pearson Education, Inc. All rights reserved.