Chapter 5 - Principles of Finance FIN 3100 Chapter 5...

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Unformatted text preview: Principles of Finance FIN 3100 Chapter 5 Interest Rates 1 Patty Robertson Agenda Discuss how interest rates are quoted, and compute the effective annual rate (EAR). Explain the real rate of interest and the effect of inflation on nominal interest rates. Summarize the two major premiums that differentiate interest rates. 2 Abbreviations 3 More Abbreviations 4 Interest Rates Borrowing money costs money. Sometimes convention influences rate quotation; sometimes it is governed. Sometimes, those extending credit deliberately mislead borrowers. Understanding how rates are quoted, and how to convert them for financial analysis, is critical. 5 Compounding Periods In Chapter 3, we acknowledged that not all interest is compounded annually. It could be compounded daily, weekly, monthly, quarterly, or semi-annually. We can use our formulas, but they require some modification. We need to adjust the compounding periods ( t ). 6 Interest Rates In Financial Analysis Is 10% compounded semi-annually the same thing as 10% compounded annually? Which would you rather have? 10% compounded semi-annually is 10% / 2 = 5% paid every six months. $1,000(1.1) = $1,100.00 $1,000(1.05)2 = $1,102.50 10.25% [($1,102.50-$1,000) / $1,000] 7 Interest Rates In Financial Analysis To be comparable, rates must be converted to effective rates . The interest rate that is expressed as if it were compounded once per year. It is the true rate of interest. EAR of 10% compounded annually = 10% 8 Interest Rates In Financial Analysis The relationship between a quoted rate, such as an annual percentage rate (APR), and the effective annual rate (EAR) is: EAR = (1 + Quoted rate /m ) m 1 where m is the number of times during the year the money is compounded (the number of payments during the year). 9 EAR = 1 + APR m m ( 29- 1 Which Would You Choose? 1. 16% compounded annually? 2. 15.5% compounded quarterly? 3. 15% compounded daily? 10 Which Would You Choose? 1. 16% compounded annually? EAR = 16% 2. 15.5% compounded quarterly? EAR = [1 + (.155/4)]4 1 = 16.42% 11 Which Would You Choose? Before we looked at 15.5% compounded quarterly The EAR = 16.42% 15.5% compounded quarterly = 16.42% compounded annually (1 + .155/4)4 = (1 + .1642) Assume you invest $1,000: $1,000(1 + .155/4)4 = $1,164.24 12 Making Sense of Quoted Rates The highest quoted rate is not necessarily the best rate....
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This document was uploaded on 11/03/2011 for the course FIN 3100 at Kennesaw.

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Chapter 5 - Principles of Finance FIN 3100 Chapter 5...

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