Chapter 5

Interest rate
Financial Management

Westfield State University

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 The Opportunity Cost of Capital
Learning Objectives
• Understand the different ways interest rates
are quoted
• Use quoted rates to calculate loan payments
and balances
• Know how inflation, expectations, and risk combine to determine interest rates
• See the link between interest rates in the market and a firm’s opportunity cost of
capital
5.1 Interest Rate Quotes and
Adjustments
• Interest rates are the price of using money
• Effective Annual Rate (EAR) aka Annual Percentage Yield (APY)
• The total amount of interest that will be earned at the end of one year
5.1 Interest Rate Quotes and
Adjustments
• The Effective Annual Rate
• With an EAR of 5%, a $100 investment grows to:
• $100  (1 + r) = $100  (1.05) = $105
• After two years it will grow to:
• $100  (1 + r)2 = $100  (1.05)2 = $110.25
5.1 Interest Rate Quotes and
Adjustments
• Adjusting the Discount Rate to Different Time Periods
• In general, by raising the interest rate factor (1 + r) to the appropriate power,
we can compute an equivalent interest rate for a longer (or shorter) time
period
5.1 Interest Rate Quotes and
Adjustments
• Adjusting the Discount Rate to Different Time Periods
• (1 + r)0.5 = (1.05)0.5 = $1.0247, so a yearly rate of 5%, is equivalent to a rate of 2.47% every
half of a year.
5.1 Interest Rate Quotes and
Adjustments
• Adjusting the Discount Rate to Different Time Periods
• A discount rate of r for one period can be converted to an equivalent
discount rate for n periods:

Equivalent n-Period Discount Rate = (1 + r)n – 1 (Eq. 5.1)

• When computing present or future values, you should adjust the discount
rate to match the time period of the cash flows
Example 5.1 Valuing Monthly Cash
Flows
Problem:
• Suppose your bank account pays interest monthly with an effective annual rate of 6%. What
amount of interest will you earn each month?
• If you have no money in the bank today, how much will you need to save at the end of each
month to accumulate $100,000 in 10 years?
Example 5.1 Valuing Monthly Cash
Flows
Solution
Plan:
• We can use Eq. 5.1 to convert the EAR to a monthly rate, answering the first part of the question.
The second part of the question is a future value of annuity question. It is asking how big a
monthly annuity we would have to deposit in order to end up with $100,000 in 10 years.
However, in order to do this problem, we need to write the timeline in terms of monthly periods
because our cash flows (deposits) will be monthly:
Example 5.1 Valuing Monthly Cash
Flows
Plan (cont’d):

• That is, we can view the savings plan as a monthly annuity with 10  12 = 120 monthly payments.
We have the future value of the annuity ($100,000), the length of time (120 months), and we will
have the monthly interest rate from the first part of the question. We can then use the future
value of annuity formula (Eq. 4.6) to solve for the monthly deposit
Example 5.1 Valuing Monthly Cash
Flows
Execute:
• From Eq. 5.1, a 6% EAR is equivalent to earning (1.06)1/12 – 1 = 0.4868% per month. The exponent
in this equation is 1/12 because the period is 1/12th of a year (a month).

• To determine the amount to save each month to reach the goal of $100,000 in 120 months, we
must determine the amount C of the monthly payment that will have a future value of $100,000
in 120 months, given an interest rate of 0.4868% per month. Now that we have all of the inputs in
terms of months (monthly payment, monthly interest rate, and total number of months), we use
the future value of annuity formula from Chapter 4 to solve this problem:

FV( annuity) C  1r [(1  r ) n  1]

 Example 5.1 Valuing Monthly Cash
Flows
Execute (cont’d):
• We solve for the payment C using the equivalent monthly interest rate r = 0.4868%, and n = 120
months:

FV (annuity) $100, 000

C n
 120
$615.47 per month
1 [(1  r )  1] 1 [(1.004868)  1]
r 0.004868

• With financial calculator

Given: 120 0.4868 0 100,000

Solve for: -615.47
Excel Formula: =PMT(RATE,NPER,PV,FV)=PMT(.004868,120,0,100000)
Example 5.1 Valuing Monthly Cash
Flows
Evaluate:
• Thus, if we save $615.47 per month and we earn interest monthly at an effective annual rate of
6%, we will have $100,000 in 10 years.
• Notice that the timing in the annuity formula must be consistent for all of the inputs.
• In this case, we had a monthly deposit, so we needed to convert our interest rate to a monthly
interest rate and then use total number of months (120) instead of years.
5.1 Interest Rate Quotes and
Adjustments
• Annual Percentage Rates (APR)
• Indicates the amount of interest earned in one year without the effect of
compounding
• Simple Interest
• Interest earned without the effect of compounding
5.1 Interest Rate Quotes and
Adjustments
• Annual Percentage Rates (APR)
• Because the APR does not reflect the true amount you will earn over one
year, the APR itself cannot be used as a discount rate
• Instead, the APR is a way of quoting the actual interest earned each
compounding period:

APR
Interest Rate per Compounding Period  (Eq. 5.2)
m
(m number of compounding periods per year)
5.1 Interest Rate Quotes and
Adjustments
• Annual Percentage Rates (APR)
• Converting an APR to an EAR
• Once the interest earned per compounding period is computed from Eq. (5.2), the
equivalent interest rate for any other time interval can be computed

m
 APR 
1  EAR  1   (Eq. 5.3)
 m 
(m = number of compounding periods per year)
Table 5.1 Effective Annual Rates for a 6% APR with
Different Compounding Periods
Example 5.2
Converting the APR to a Discount Rate
Problem:
• Your firm is purchasing a new telephone system that will last for four years.
You can purchase the system for an upfront cost of $150,000, or you can
lease the system from the manufacturer for $4,000 paid at the end of each
month. The lease price is offered for a 48-month lease with no early
termination—you cannot end the lease early. Your firm can borrow at an
interest rate of 6% APR with monthly compounding. Should you purchase
the system outright or pay $4,000 per month?
Example 5.2
Converting the APR to a Discount Rate
Solution:
Plan:
• The cost of leasing the system is a 48-month annuity of $4,000 per month:
Example 5.2
Converting the APR to a Discount Rate

Plan (cont’d):
• We can compute the present value of the lease cash flows using the annuity
formula, but first we need to compute the discount rate that corresponds to
a period length of one month. To do so, we convert the borrowing cost of
6% APR with monthly compounding to a monthly discount rate using Eq.
5.2. Once we have a monthly rate, we can use the present value of annuity
formula Eq. 4.5 to compute the present value of the monthly payments and
compare it to the cost of buying the system.
Example 5.2 - Converting the APR to a Discount
Rate
Execute:
• As Eq. 5.2 shows, the 6% APR with monthly compounding really means 6%/12=0.5% every month.
The 12 comes from the fact that there are 12 monthly compounding periods per year. Now that
we have the true rate corresponding to the stated APR, we can use that discount rate in the
annuity formula Eq. 4.6 to compute the present value of the monthly payments:

1  1 
PV 4000  1  48 
$170,321.27
0.005  1.005 

Given: 48 0.5 -4,000 0

Solve for: 170,321.27
Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.005,48,-4000,0)
Example 5.2
Converting the APR to a Discount Rate
Evaluate:
• Thus paying $4,000 per month for 48 months is equivalent to paying a
present value of $170,321.27 today. This cost is $170,321.27 – $150,000 =
$20,321.27 higher than the cost of purchasing the system, so it is better to
pay $150,000 for the system rather than lease it. One way to interpret this
result is as follows: At a 6% APR with monthly compounding, by promising
to repay $4,000 per month your firm can borrow $170,321 today. With this
loan it could purchase the phone system and have an additional $20,321 to
use for other purposes.
5.2 Application:
Discount Rates and Loans
• Computing Loan Payments
• Consider the timeline for a $30,000 car loan with these terms: 6.75% APR for
60 months
5.2 Application:
Discount Rates and Loans
• Computing Loan Payments
• We can use Eq. 4.9 to find C
• Note: 0.0675/12 = 0.005625
5.2 Application:
Discount Rates and Loans
• Computing Loan Payments
• Alternatively, we can solve for the payment C using a financial calculator or a
spreadsheet:

Given: 60 0.5625 30000 0

Solve for: -590.50

Excel Formula: =PMT(RATE,NPER, PV, FV) = PMT(0.005625,60,30000,0)

Figure 5.1 Amortizing Loan

cont.
Figure 5.1 Amortizing Loan (cont.)
Example 5.3 Computing the
Outstanding Loan Balance
Problem:
• Let’s say that you are now 3 years into a $30,000 car loan (at 6.75% APR, originally for 60 months)
and you decide to sell the car. When you sell the car, you will need to pay whatever the remaining
balance is on your car loan. After 36 months of payments, how much do you still owe on your car
loan?
Example 5.3 Computing the
Outstanding Loan Balance
Solution:
Plan:
• We have already determined that the monthly payments on the loan are $590.50. The remaining
balance on the loan is the present value of the remaining 2 years, or 24 months, of payments.
Thus, we can just use the annuity formula with the monthly rate of 0.5625%, a monthly payment
of $590.50, and 24 months remaining.
Example 5.3 Computing the
Outstanding Loan Balance
Execute:
• Thus, after 3 years, you owe $13,222.32 on the loan

1  1 
Balance with 24 months remaining $590.50   1  24 
$13, 222.32
0.005625  1.005625 

Given: 24 0.5625 -590.50 0

Solve for: 13,222.32

Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.005625,24,‑590.50,0)

Example 5.3 Computing the
Outstanding Loan Balance
Execute:
• You could also compute this as the FV of the original loan amount after deducting payments:

Given: 36 0.5625 30,000 -590.50

Solve for: 13,222.41
Excel Formula: =FV(RATE,NPER, PMT, PV) =
FV(0.005625,36,‑590.50,30000)
Example 5.3 Computing the
Outstanding Loan Balance
Evaluate:
• Any time that you want to end the loan, the bank will charge you a lump sum equal to the
present value of what it would receive if you continued making your payments as planned.
• As the second approach shows, the amount you owe can also be thought of as the future value of
the original amount borrowed after deducting payments made along the way.
5.3 The Determinants of Interest
Rates
• Inflation and Real Versus Nominal Rates
• Nominal Interest Rates
• The rate at which your money will grow if invested for a certain period
• Real Interest Rate
• The rate of growth of your purchasing power, after adjusting for inflation
5.3 The Determinants of Interest
Rates
• Inflation and Real Versus Nominal Rates
• The growth in purchasing power can be calculated using
Equation 5.4:

1 + Nominal rate
Growth in Purchasing Power 1  Real Rate 
1 + Inflation rate
Growth of Money (Eq. 5.4)

Growth of Prices
5.3 The Determinants of Interest
Rates
• Inflation and Real Versus Nominal Rates
• The Real Interest Rate can be calculated using Equation 5.5:

Nominal Rate  Inflation Rate

Real Rate   Nominal Rate  Inflation Rate
1  Inflation rate

(Eq. 5.5)
Example 5.4
Calculating the Real Interest Rate
Problem:
• At the start of 2008, one-year U.S. government bond rates were about 3.3%, while the inflation
rate that year was 0.1%. At the start of 2011, one-year interest rates were about 0.3%, and the
inflation rate that year was about 3.0%. What were the real interest rates in 2008 and in 2011?
Example 5.4
Calculating the Real Interest Rate
Solution:
• Using Eq. 5.5, the real interest rate in 2008 was (3.3% - 0.1%)/(1.001) = 3.20%. In 2011, the
real interest rate was (0.3% - 3.0%)/(1.03) = -2.62%.
Example 5.4
Calculating the Real Interest Rate
Evaluate:
• Note that the real interest rate was negative in 2011, indicating that interest rates were
insufficient to keep up with inflation: Investors in U.S. government bonds were able to buy less at
the end of the year than they could have purchased at the start of the year. On the other hand,
there was hardly any inflation.
Figure 5.2 U.S. Interest Rates and
Inflation Rates, 1962 -2013
5.3 The Determinants of Interest
Rates
• Investment and Interest Rate Policy
• When the costs of an investment precede the benefits, an increase in the
interest rate will decrease the investment’s NPV
• Monetary Policy, Deflation, and the 2008 Financial Crisis
• During 2008, in response to the financial crisis, the U.S. Federal Reserve responded by
cutting its short-term interest rate target to 0% by the end of the year
• Because consumer prices were falling in late 2008, the inflation rate was negative
(deflation), and so even with a 0% nominal interest rate the real interest rate remained
positive initially
• Since rates could not go lower than 0%, the United States began to consider other
measures, such as increased government spending and investment, to stimulate their
economies
5.3 The Determinants of Interest
Rates
• The Yield Curve and Discount Rates
• Term Structure
• The relationship between the investment term and the interest rate
• Yield Curve
• A plot of bond yields as a function of the bonds’ maturity date
• Risk-Free Interest Rate
• The interest rate at which money can be borrowed or lent without risk over a given
period.
Figure 5.3 Term Structure of Risk-Free U.S.
Interest Rates, November 2006, 2007, and
2008
5.3 The Determinants of Interest
Rates
• The Yield Curve and Discount Rates
• A risk-free cash flow of Cn received in n years has the present value

Cn
PV  n
(Eq. 5.6)
(1  rn )

where rn is the risk-free interest rate for an n-year

term
5.3 The Determinants of Interest
Rates
• The Yield Curve and Discount Rates
• Present Value of a Cash Flow Stream Using a Term Structure of Discount Rates

C1 C2 CN
PV =  2
  (Eq. 5.7)
1 + r1 (1 + r2 ) (1 + rN ) N
Example 5.5 Using the Term Structure
to Compute Present Values
Problem:
• Compute the present value of a risk-free five-year annuity of $1,000 per
year, given the yield curve for November 2008 in Figure 5.3.
Example 5.5 Using the Term Structure
to Compute Present Values
Solution:
Plan:
• The timeline of the cash flows of the annuity is:

0 1 2 3 4 5

$1000 $1000 $1000 $1000 $1000

• We can use the table next to the yield curve to identify the interest rate
corresponding to each length of time: 1, 2, 3, 4 and 5 years. With the cash
flows and those interest rates, we can compute the PV
 Example 5.5 Using the Term Structure
to Compute Present Values
Execute:
• From Figure 5.3, we see that the interest rates are: 0.91%, 0.98%, 1.26%, 1.69% and 2.01%, for terms
of 1, 2, 3, 4 and 5 years, respectively.
• To compute the present value, we discount each cash flow by the corresponding interest rate:

• PV = 1000/1.0091 + 1000 / (1.0098^2) + 1000 / (1.0126^3) + 1000/1.0169^4 + 1000/1.0201^5

= 4765.6
Example 5.5 Using the Term Structure
to Compute Present Values
Evaluate:
• The yield curve tells us the market interest rate per year for each different
maturity.
• In order to correctly calculate the PV of cash flows from five different
maturities, we need to use the five different interest rates corresponding to
those maturities.
• Note that we cannot use the annuity formula here because the discount
rates differ for each cash flow.
Example 5.5a Using the Term Structure
to Compute Present Values
Problem:
• Compute the present value of a risk-free five-year annuity of $2,500 per
year, given the following yield curve for July 2009.

Term Date
Years July-09
1 0.54%
2 1.05%
3 1.57%
4 2.05%
5 2.51%
Example 5.5a Using the Term Structure
to Compute Present Values
Solution:
Plan:
• The timeline of the cash flows of the annuity is:
0 1 2 3 4 5

$2,500 $2,500 $2,500 $2,500 $2,500

• We can use the table next to the yield curve to identify the interest rate
corresponding to each length of time:1, 2, 3, 4 and 5 years. With the cash
flows and those interest rates, we can compute the PV
Example 5.5a Using the Term Structure
to Compute Present Values
Execute:
• From the yield curve, we see that the interest rates are: 0.54%, 1.05%,
1.57%, 2.05% and 2.51%, for terms of 1, 2, 3, 4 and 5 years, respectively.
• To compute the present value, we discount each cash flow by the
corresponding interest rate:

$2,500 $2,500 $2,500 $2,500 $2,500

PV   2
 3
 4
 5
$11,834.39
1.0054 1.0105 1.0157 1.0205 1.0251
5.3 The Determinants of Interest
Rates
• Interest Rate Determination
• Federal Funds Rate
• The overnight loan rate charged by banks with excess reserves at a Federal Reserve bank
to banks that need additional funds to meet reserve requirements
• The Federal Reserve determines very short-term interest rates through its influence on
the federal funds rate
5.3 The Determinants of Interest
Rates
• The Yield Curve and the Economy
• Interest Rate Determination
• If interest rates are expected to rise, long-term interest rates will tend to be higher than
short-term rates to attract investors
• If interest rates are expected to fall, long-term rates will tend to be lower than short-
term rates to attract borrowers
5.3 The Determinants of Interest
Rates
• The Yield Curve and the Economy
• Yield Curve Shapes
• Normal
• Moderately upward sloping
• Steep
• Long-term rates are much higher than short-term rates
• Inverted
• Long-term rates lower than short-term rates
Figure 5.4 Yield Curve Shapes
Figure 5.5 Short-Term versus Long-Term
U.S. Interest Rates and Recessions
Example 5.6
Long-Term versus Short-Term Loans
Problem:
• You work for a bank that has just made two loans. In one, you loaned $909.09 today in return for
$1,000 in one year. In the other, you loaned $909.09 today in return for $15,863.08 in 30 years.
The difference between the loan amount and repayment amount is based on an interest rate of
10% per year.
Example 5.6
Long-Term versus Short-Term Loans
Problem (cont’d):
• Imagine that immediately after you make the loans, news about economic growth is announced
that increases inflation expectations so that the market interest rate for loans like these jumps to
11%. Loans make up a major part of a bank’s assets, so you are naturally concerned about the
value of these loans. What is the effect of the interest rate change on the value to the bank of
the promised repayment of these loans?
Example 5.6
Long-Term versus Short-Term Loans
Solution:
Plan:
• Each of these loans has only one repayment cash flow at the end of the loan. They differ only by
the time to repayment:

• The effect on the value of the future repayment to the bank today is just the PV of the loan
repayment, calculated at the new market interest rate.
Example 5.6
Long-Term versus Short-Term Loans
Execute:

For the one-year loan: $1,000

PV  $900.90
1.111

$15,863.08
For the 30-year loan: PV  $692.94
1.1130
Example 5.6
Long-Term versus Short-Term Loans
Evaluate:
• The value of the one-year loan decreased by $909.09 - $900.90 = $8.19, or 0.9%, but the value of
the 30-year loan decreased by $909.09 - $692.94 = $216.15, or almost 24%!
• The small change in market interest rates, compounded over a longer period, resulted in a much
larger change in the present value of the loan repayment.
• You can see why investors and banks view longer-term loans as being riskier than short-term
loans!
5.4 The Opportunity Cost of Capital
• Opportunity Cost of Capital aka Cost of Capital
• The best available expected return offered in the market on an investment of
comparable risk and term to the cash flow being discounted
Example 5.7 The Opportunity Cost
of Capital
Problem:
• Suppose a friend offers to borrow $100 from you today and in return pay you $110 one year from
today. Looking in the market for other options for investing your money, you find your best
alternative option for investing the $100 that view as equally risky as lending it to your friend.
That option has an expected return of 8%. What should you do?
Example 5.7
The Opportunity Cost of Capital
Solution:
Plan:
• Your decision depends on what the opportunity cost is of lending your money to your friend. If
you lend her the $100, then you cannot invest it in the alternative with an 8% expected return.
Thus, by making the loan, you are giving-up the opportunity to invest for an 8% expected return.
Thus, you can make your decision by using your 8% opportunity cost of capital to value the $110
in one year.
Example 5.7
The Opportunity Cost of Capital
Execute:
• The value of the $110 in one year is its present value, discounted at 8%:

$110
PV  $101.85
1.08 
1

• The $100 loan is worth $101.85 to you today, so you should make the loan.
Example 5.7
The Opportunity Cost of Capital
Evaluate:
• The Valuation Principle tells us that we can determine the value of an investment by using market
prices to value the benefits net of the costs. As this example shows, market prices determine
what our best alternative opportunities are, so that we can decide whether an investment is
worth the cost.