Topic 3a - Interest Rates

Financial Management: Core Concepts
Fourth Edition
Chapter 5
Interest Rates
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (1 of 2)
5.1 Discuss how financial institutions quote interest rates and
compute the effective annual rate (EAR) on a loan or
investment.
5.2 Apply the TVM equations by accounting for the
compounding periods per year.
5.3 Set up monthly amortization tables for consumer loans,
and illustrate the payment changes as the compounding
or annuity period changes.
5.4 Explain the real rate of interest and the impact of inflation
on nominal rates.
Learning Objectives (2 of 2)
5.5 Summarize the two major premiums that differentiate
interest rates: the default premium and the maturity
premium.
5.6 Understand the implications of yield curves.
5.7 Amaze your family and friends with your knowledge of
interest rate history.
5.1 How Financial Institutions Quote Interest
Rates: Annual and Periodic Interest Rates (1 of 2)
• Most common rate quoted is the annual percentage rate (APR).
• It is the annual rate based on interest being computed once a year.
• Lenders often charge interest on a non-annual basis.
• In such a case, the APR is divided by the number of compounding
periods per year (C ÷ Y or “m”) to calculate the periodic interest rate.
For example: APR = 12%; m = 12; i % = 12% ÷ 12 = 1%
• The effective annual rate (EAR) is the true rate of return to the lender
and true cost of borrowing to the borrower.
• An EAR, also known as the annual percentage yield (APY) on an
investment, is calculated from a given APR and frequency of
compounding (m) by using the following equation:
( m)
 APR 
EAR = 1 +  −1
 m 
5.1 How Financial Institutions Quote Interest
Rates: Annual and Periodic Interest Rates (2 of 2)
Example 1: Calculating EAR or APY
The First Common Bank has advertised one of its loan offerings as
follows:
“We will lend you $100,000 for up to 3 years at an APR of 8.5% (interest
compounded monthly.” If you borrow $100,000 for 1 year, how much
interest will you have paid and what is the bank’s APY?
Answer
Nominal annual rate = APR = 8.5%
Frequency of compounding = C ÷ Y = m = 12
Periodic interest rate = APR ÷ m = 8.5% ÷ 12 = 0.70833% = 0.0070833
APY or EAR = (1.0070833)12 − 1 = 1.08839 − 1 = 8.839%

Total interest paid after 1 year = 0.08839 × $100,000 = $8,839.09
5.2 Effect of Compounding Periods on Time
Value of Money Equations (1 of 5)
• TVM equations require the periodic rate (r %) and the
number of periods (n) to be entered as inputs.
• The greater the frequency of payments made per year, the
lower the total amount paid.
• More money goes to principal and less interest is charged.
• The interest rate entered should be consistent with the
frequency of compounding and the number of payments
involved.
Example 2: Effect of Payment Frequency on Total
Payment
Jim needs to borrow $50,000 for a business expansion
project. His bank agrees to lend him the money over a 5-
year term at an APR of 9% and will accept either annual,
quarterly, or monthly payments with no change in the quoted
APR. Calculate the periodic payment under each alternative
and compare the total amount paid each year under each
option.
Example 2: Answer
Loan amount = $50,000
Loan period = 5 years
APR = 9%
Annual payments: PV = 50,000; n = 5; i = 9; FV = 0; P ÷ Y = 1; C ÷ Y = 1;
CPT PMT = $12,854.62
Quarterly payments: PV = 50,000; n = 20; i = 9; FV = 0; P ÷ Y = 4; C ÷ Y
= 4; CPT PMT = $3132.10
Total annual payment = $3132.1 × 4 = $12,528.41
Monthly payments: PV = 50,000; n = 60; i = 9; FV = 0; P ÷ Y = 12; C ÷ Y
= 12; CPT PMT = $1037.92
Total annual payment = $1037.92 × 12 = $12,455.04
Example 3: Comparing Annual and Monthly Deposits
Joshua, who is currently 25 years old, wants to invest money
into a retirement fund so as to have $2,000,000 saved up
when he retires at age 65. If he can earn 12% per year in an
equity fund, calculate the amount of money he would have to
invest in equal annual amounts and alternatively, in equal
monthly amounts starting at the end of the current year or
month respectively.
Example 3: Answer
With annual deposits: With monthly deposits:

(Using the APR as the interest rate)
FV = $2,000,000; FV = $2,000,000;
N = 40 years; N = 12 × 40 = 480;
I ÷ Y = APR = 12%; I ÷ Y = APR = 12%;
PV = 0; PV = 0;
C ÷ Y = 1; C ÷ Y = 12;
P ÷ Y = 1; P ÷ Y = 12;
PMT = $2,607.25 PMT = $169.99
5.3 Consumer Loans and Amortization
Schedules (1 of 4)
Interest is charged only on the outstanding balance of a
typical consumer loan.
Increases in frequency and size of payments result in
reduced interest charges and quicker payoff due to more
money being applied to loan balance each month.
Amortization schedules help in planning and analysis of
consumer loans.
Schedules (2 of 4)
Example 4: Paying Off a Loan Early!
Kay has just taken out a $200,000, 30-year, 5%, mortgage.
She has heard from friends that if she increases the size of
her monthly payment by one-twelfth of the monthly payment,
she will be able to pay off the loan much earlier and save a
bundle on interest costs. She is not convinced.
Use the necessary calculations to help convince her that this
is in fact true.
Schedules (3 of 4)
Example 4: Answer
We first solve for the required minimum monthly
payment:
PV = $200,000; I ÷ Y = 5; N = 30 × 12 = 360; FV = 0; C ÷ Y
= 12; P ÷ Y = 12; PMT = ? → $1073.64
Next, we calculate the number of payments required to
pay off the loan, if the monthly payment is increased by
1 ÷ 12 × $1073.64 i.e., by $89.47
PMT = 1163.11; PV = $200,000; FV = 0; I ÷ Y = 5; C ÷ Y =
12; P ÷ Y = 12; N = ? → N = 303.13 months or 303.13 ÷ 12
= 25.26 years
Schedules (4 of 4)
Example 4: Answer (continued)
With minimum monthly payments:
Total paid = 360 × $1073.64 = $386,510.4
Amount borrowed = $200,000.0
Interest paid = $186,510.4
With higher monthly payments:
Total paid = 303.13 × $1163.11 = $353,573.53
Amount borrowed = $200,000.00
Interest paid = $153,573.53
Interest saved = $186,510.4 − $153,573.53 = $32,936.87
5.4 Nominal and Real Interest Rates (1 of 3)
• The nominal risk-free rate is the rate of interest earned on a
risk-free investment such as a bank CD or a treasury security.
• It is essentially a compensation paid for the giving up of current
consumption by the investor.
• The real rate of interest adjusts for the erosion of purchasing
power caused by inflation.
• The Fisher Effect shown below is the equation that shows the
relationship between the real rate (r*), the inflation rate (h), and
the nominal interest rate (r):
(1 + r) = (1 + r*) × (1 + h)
→ r = (1 + r*) × (1 + h) − 1
→ r = r* + h + (r* × h)
Example 5: Calculating Nominal and Real Interest Rates
Jill has $100 and is tempted to buy 10 t-shirts, with each one
costing $10. However, she realizes that if she saves the
money in a bank account she should be able to buy 11 t-shirts.
If the cost of the t-shirt increases by the rate of inflation, i.e.
4%, how much would her nominal and real rates of return
have to be?
Example 5: Answer (continued)
Real rate of return = (FV ÷ PV)1 ÷ n −1
= (11 shirts ÷ 10 shirts)1 ÷ 1 − 1
= 10%
Price of t-shirt next year = $10(1.04) = $10.40
Total cost of 11 t-shirts = $10.40 × 11 = $114.40 = FV
PV = $100; n = 1; I ÷ Y = (FV ÷ PV) − 1 = (114.4 ÷ 100) − 1
= 14.4%
Nominal rate of return = 14.4%
= Real rate + Inflation rate + (real rate × inflation rate)
= 10% + 4% + (10% × 4%) = 14.4%
5.5 Risk-Free Rate and Premiums
• The nominal risk-free rate of interest such as the rate of
return on a treasury bill includes the real rate of interest (r*)
and the inflation premium (h).
• The rate of return on all other riskier investments
(r ) would have to include a default risk premium (dp) and a
maturity risk premium (mp), i.e.,
r = r* + h + dp + mp
• 30-year corporate bond yield > 30-year T-bond yield
– Due to the increased length of time and the higher default risk on
the corporate bond investment.
5.6 Yield Curves
• A yield curve is a graphical depiction of the relationship
between the interest rate and the maturity date of a
financial instrument.
• Although most yield curves tend to be “upward sloping,”
they can take on various shapes, such as being
“downward sloping” or “inverted” and flat, over time.
5.6 Types of Yield Curves (1 of 2)
Upward Sloping
Figure 5.2 Upward-Sloping Yield Curve
5.6 Types of Yield Curves (2 of 2)
Downward Sloping
Figure 5.3 Downward-Sloping Yield Curve
5.7 A Brief History of Interest Rates and
Inflation in the United States (1 of 6)
Figure 5.4 Inflation Rates in the United States, 1950–1999
Figure 5.5 Interest Rates for the Three-Month Treasury
Bill, 1950–1999
Table 5.5 Yields on Treasury Bills, Treasury Bonds, and

AAA Corporate Bonds, 1950–1999
Blank Treasury Bill Treasury Bond AAA Corporate Bond
Average 5.23% 6.64% 7.13%
Standard deviation 2.98% 2.86% 2.95%
Source: Data from Federal Reserve Bank of St. Louis.
Table 5.6 Yields on Treasury Bills, Treasury Bonds, and
AAA Corporate Bonds, 2000–2016
Year Treasury Bill Treasury Bond AAA Corporate Bond
2000 5.66% 5.24% 7.15%
2001 1.70% 5.09% 6.66%
2002 1.16% 4.03% 6.14%
2003 0.88% 4.27% 5.55%
2004 2.20% 4.23% 5.51%
2005 3.92% 4.47% 5.24%
2006 4.87% 4.56% 5.43%
2007 3.17% 4.10% 5.57%
2008 0.03% 2.42% 4.72%
2009 0.05% 3.59% 5.32%
Table 5.6 Continued
Year Treasury Bill Treasury Bond AAA Corporate Bond
2010 0.14% 3.29% 4.98%
2011 0.11% 2.98% 3.93%
2012 0.15% 2.88% 3.65%
2013 0.13% 3.89% 4.62%
2014 0.03% 2.17% 5.04%
2015 0.23% 2.31% 6.95%
2016 0.51% 2.45% 4.22%
Average 1.47% 3.66% 5.33%
Standard Dev. 1.80% 0.96% 0.96%
Source: Data from Federal Reserve Bank of St. Louis.
• A 50-year analysis (1950–1999) of the historical
distribution of interest rates on various types of
investments in the United States shows:
• Inflation at 4.05%,
• Real rate at 1.18%,
• Default premium of 0.49% (for AAA-rated over government
bonds) and,
• Maturity premium of 1.28% (for 20-year maturity
differences).
Additional Problems with Answers
Problem 1
Calculating APY or EAR. The First Federal Bank has
advertised one of its loan offerings as follows:
“We will lend you $100,000 for up to 5 years at an APR of
9.5% (interest compounded monthly).”
If you borrow $100,000 for 1 year and pay it off in one lump
sum at the end of the year, how much interest will you have
paid and what is the bank’s APY?
Problem 1 (Answer)
Nominal annual rate = APR = 9.5%
Frequency of compounding = C ÷ Y = m = 12
Periodic interest rate = APR ÷ m = 9.5% ÷ 12 = 0.79167%
= 0.0079167
( m)
 APR 
EAR = 1+  −1
 m 
APY or EAR = (1.0079167)12 − 1 = 1.099247 − 1 → 9.92%

Payment at the end of the year = 1.099247 × 100,000
→ $109,924.70
Amount of interest paid = $109, 924.7 − $100,000
→ $9,924.7
Problem 2
EAR with Monthly Compounding. If First Federal offers to
structure the 9.5%, $100,000, 1 year loan on a monthly
payment basis, calculate your monthly payment and the
amount of interest paid at the end of the year. What is your
EAR?
Problem 2 (Answer)
N I÷y PV PMT FV
12 9.5 ÷ 12 100,000 −8,768.35 0
Calculate monthly payment:

Total interest paid after 1 year = 12 × $8,768.35 − $100,000
= $105,220.20 − $100,000
= $5,220.20
EAR is still 9.92%, since the APR and m are the same as
#1 above,
APY or EAR = (1.0079167)12 − 1 = 1.099247 − 1 = 9.92%
Problem 3
Monthly versus Quarterly Payments. Patrick needs to
borrow $70,000 to start a business expansion project. His
bank agrees to lend him the money over a 5-year term at an
APR of 9.25% and will accept either monthly or quarterly
payments with no change in the quoted APR.
Calculate the periodic payment under each alternative and
compare the total amount paid each year under each option.
Which payment term should Patrick accept and why?
Problem 3 (Answer) (1 of 2)
Calculate monthly payment:
N = 60; i ÷ y = 9.25% ÷ 12; PV = 70,000; FV = 0;
PMT = 1,461.59
Calculate quarterly payment:

N = 20; i ÷ y = 9.25% ÷ 4; PV = 70,000; FV = 0;
PMT = 4,411.15
Total amount paid per year under each payment type:

With monthly payments = 12 × $1,461.59 = $17,539.08
With quarterly payments = 4 × $4,411.15 = $17,644.60
Problem 3 (Answer) (2 of 2)
Total interest paid under monthly compounding
→Total paid − Amount borrowed
= 60 × $1,461.59 − $70,000
= $87,695.4 − $70,000
= $17,695.4
Total interest paid under quarterly compounding
→ 20 × $4,411.15 − $70,000
= $88,223 − $70,000
= $18,223
Since less interest is paid over the 5 years with the monthly
payment terms, Patrick should accept monthly rather than quarterly
payment terms.
Problem 4
Computing Payment for Early Payoff. You have just taken
on a 30-year, 6%, $300,000 mortgage and would like to pay
it off in 15 years. By how much will your monthly payment
have to change to accomplish this objective?
Problem 4 (Answer)
Calculate the current monthly payment under the 30-year,
6% terms:
n = 360; i ÷ y = 6% ÷ 12; PV = 300,000; FV = 0;
CPT PMT → 1,798.65
Next, calculate the payment required to pay off the loan in
15 years or 180 payments
n = 180; i ÷ y = 6% ÷ 12; PV = 300,000; FV = 0;
CPT PMT → 2,531.57
The increase in monthly payment required to pay off the
loan in 15 years = $2,531.57 − $1,798.65 = $732.92
Problem 5
You just turned 30 and decide that you would like to save up
enough money so as to be able to withdraw $75,000 per
year for 20 years after you retire at age 65, with the first
withdrawal starting on your 66th birthday. How much money
will you have to deposit each month into an account earning
8% per year (interest compounded monthly), starting one
month from today, to accomplish this goal?
Problem 5 (Answer)
Calculate the amount of money needed to be accumulated
at age 65 to provide an annuity of $75,000 for 20 years with
the account earning 8% per year (interest compounded
monthly)
n = 20; i ÷ y = 8%; FV = 0; PMT = 75,000; P ÷ Y = 1; C ÷ Y = 12
CPT PV → 720,210.86
Next, calculate the monthly deposit necessary to

accumulate a FV of $720,210.86 over 35 years or 12 × 35 =
420 months:
n = 420; i ÷ y = 8%; FV = 720,210.86; P ÷ Y = 12; C ÷ Y = 12
CPT PMT → 313.97
Table 5.1 Periodic Interest Rates
Compounding Annual
Period Percentage Rate C/Y = m Periodic Rate (r)
Annually 5.0% 1 5.0%
Quarterly 5.0% 4 1.25%
Monthly 5.0% 12 0.4167%
Daily 5.0% 365 0.013699%
Table 5.2 $500 CD with 5% APR,
Compounded Quarterly at 1.25%
Beginning Ending
Date Balance Interest Earned Balance
1/1–3/31 $500.00 $500.00 × 0.0125 = $6.25 $506.25
4/1–6/30 $506.25 $506.25 × 0.0125 = $6.33 $512.58
7/1–9/30 $512.58 $512.58 × 0.0125 = $6.41 $518.99
10/1–12/31 $518.99 $518.99 × 0.0125 = $6.48 $525.47
Table 5.3 Abbreviated Monthly Amortization Schedule
for $25,000 Loan, 6 Years at 8% Annual Percentage Rate
(1 of 2)
Beginning Interest Principal Ending

Month Principal Payment Expense Reduction Principal
1 $25,000.00 $438.33 $166.67 $271.66 $24,728.34
2 $24,728.34 $438.33 $164.86 $273.47 $24,454.86
3 $24,454.86 $438.33 $163.03 $275.30 $24,179.56
4 $24,179.56 $438.33 $161.20 $277.13 $23,902.43
5 $23,902.43 $438.33 $159.35 $278.98 $23,623.45
6 $23,623.45 $438.33 $157.49 $280.84 $23,342.61
7 $23,342.61 $438.33 $155.62 $282.71 $23,059.90
8 $23,059.90 $438.33 $153.73 $284.60 $22,775.30
9 $22,775.30 $438.33 $151.84 $286.49 $22,488.81
10 $22,488.81 $438.33 $149.93 $288.40 $22,200.40
Table 5.3 Abbreviated Monthly Amortization Schedule
for $25,000 Loan, 6 Years at 8% Annual Percentage Rate
(2 of 2)
Beginning Interest Principal Ending

Month Principal Payment Expense Reduction Principal
11 $22,200.40 $438.33 $148.00 $290.33 $21,910.07
12 $21,910.07 $438.33 $146.07 $292.26 $21,617.81
⁞ Blank Blank Blank Blank Blank
23 $18,585.85 $438.33 $123.91 $314.42 $18,271.42
24 $18,271.42 $438.33 $121.81 $316.52 $17,954.90
⁞ Blank Blank Blank Blank Blank
71 $868.06 $438.33 $5.79 $432.54 $435.52
72 $435.52 $438.42 $2.90 $435.52 $0.00
Note: Values have been rounded to the nearest cent. The last payment is $0.09 higher to cover the shortfall when the
actual payments are rounded to the nearest cent.
Table 5.4 Advertised Borrowing and Investing
Rates at a Credit Union, January 22, 2012
Borrowing Certificate of Deposit Investing
Type of Loan Rate Maturity Period Rates
Real estate 30-year fixed 6.50% 90 to 181 days 2.50%
Real estate 15-year fixed 6.02% 182 to 364 days 4.00%
New auto loan 7.14% 12 to 24 months 4.15%
Used auto loan 7.24% 24 to 36 months 4.20%
New boat or RV loan 7.50% 36 to 48 months 4.25%
Used boat or RV loan 8.50% 48 to 60 months 4.30%
Visa Rewards credit card 14.45% Over 5 years 4.35%
Visa Value credit card 14.75% Blank Blank
Figure 5.1 Interest Rate Dimensions
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Financial Management: Core Concepts

APY or EAR = (1.0070833)12 − 1 = 1.08839 − 1 = 8.839%

With annual deposits: With monthly deposits:

Figure 5.2 Upward-Sloping Yield Curve

Figure 5.3 Downward-Sloping Yield Curve

Figure 5.4 Inflation Rates in the United States, 1950–1999

Table 5.5 Yields on Treasury Bills, Treasury Bonds, and

APY or EAR = (1.0079167)12 − 1 = 1.099247 − 1 → 9.92%

Calculate monthly payment:

Calculate quarterly payment:

Total amount paid per year under each payment type:

Next, calculate the monthly deposit necessary to

Beginning Interest Principal Ending

Beginning Interest Principal Ending

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