Chapter 5: Interest Rates
Comprehensive Study Notes & Comprehensive Practice Problem Set
1. Interest Rate Quotes and Adjustments
In corporate finance and financial markets, interest rates are quoted in various ways. To perform accurate time
value of money analysis, we must align the compounding frequency of the interest rate with the frequency of
cash flows.
A. Annual Percentage Rate (APR) vs. Effective Annual Rate (EAR)
The Annual Percentage Rate (APR) is the annualized interest rate stated by law or convention that does not
account for intra-year compounding. It is often referred to as the nominal or quoted rate. Conversely, the
Effective Annual Rate (EAR) is the actual rate of interest earned or paid over a full year, explicitly accounting
for the effects of compounding during the year.
To adjust an APR to an EAR, use the following structural formula:
1 + EAR = (1 + APR / m)m ⇒ EAR = (1 + APR / m)m − 1
Where m represents the number of compounding periods per year (e.g., m = 2 for semi-annual, m = 4 for
quarterly, m = 12 for monthly).
Example: Comparing Compounding Frequencies
A bank offers a loan at an APR of 12%. Calculate the EAR if interest compounds quarterly versus
monthly:
• Quarterly (m = 4): EAR = (1 + 0.12 / 4)4 − 1 = (1.03)4 − 1 = 12.55%
• Monthly (m = 12): EAR = (1 + 0.12 / 12)12 − 1 = (1.01)12 − 1 = 12.68%
B. The Fisher Effect: Nominal vs. Real Interest Rates
The nominal interest rate is the percentage change in the number of dollars you have, whereas the real
interest rate is the percentage change in your actual purchasing power, adjusting for inflation (h). The
relationship is formally defined by the Fisher Effect:
1 + R = (1 + r) × (1 + h)
Where R is the nominal rate, r is the real rate, and h is the expected inflation rate. An approximation frequently
used for low rates is R ≈ r + h.
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2. Application: Discount Rates and Loans
Understanding how interest rates apply to real-world financial contracts is essential for managing personal
and corporate leverage.
A. Pure Discount Loans
The simplest form of a loan. The borrower receives money today and repays a single lump sum (principal plus
accumulated interest) at maturity. Examples include Government Treasury Bills (T-bills).
B. Interest-Only Loans
The borrower pays interest each period and repays the entire original principal amount in one lump sum at the
end of the loan term.
C. Amortized Loans
An amortized loan requires the borrower to make regular periodic payments that cover both the accrued
interest and a portion of the principal balance. There are two standard structures:
1. Equal Principal Payments: The principal paid down each period is constant, while total payment
declines over time as interest expense drops.
2. Equal Total Payments (Annuity Style): Each periodic total payment is identical. Early payments
consist primarily of interest, while later payments consist primarily of principal reduction.
PMT = C = [ PV × C_rate ] / [ 1 − (1 + C_rate)−n ]
3. Practice Questions & Solutions
Question 1: Multi-Period Adjustment
An investment offers an APR of 8.4% with monthly compounding. What is the corresponding Effective
Annual Rate (EAR), and what is the effective rate per semi-annual period?
Solution:
1. EAR: EAR = (1 + 0.084 / 12)12 − 1 = (1.007)12 − 1 = 8.73%
2. Effective Semi-Annual Rate: Since there are 6 months in a semi-annual period, the effective 6-
month rate is (1 + 0.007)6 − 1 = 4.27%. Alternatively, √(1 + EAR) − 1 = √(1.087311) − 1 = 4.27%.
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Question 2: Amortized Loan Schedule Application
You borrow \$20,000 to purchase a car. The loan term is 4 years with an APR of 6% and monthly
payments. Calculate your fixed monthly payment and determine how much interest you will pay in the
first month.
Solution:
• Monthly interest rate = 0.06 / 12 = 0.005 (0.5% per month).
• Total periods (n) = 4 × 12 = 48 months.
• Monthly Payment = [ 20000 × 0.005 ] / [ 1 − (1.005)−48 ] = 100 / 0.212908 = \$469.70.
• Month 1 Interest Expense = \$20,000 × 0.005 = \$100.00.
• Month 1 Principal Reduction = \$469.70 − \$100.00 = \$369.70.
Question 3: Real vs. Nominal Returns (Fisher Effect)
An investor requires a 4.5% real rate of return on an asset. If the expected annual inflation rate is 3.2%,
what nominal interest rate must the asset offer?
Solution:
Using the exact Fisher Effect formula:
1 + R = (1 + r)(1 + h) = (1 + 0.045)(1 + 0.032) = 1.045 × 1.032 = 1.07844
R = 7.84% (Note: The linear approximation yields 4.5\% + 3.2\% = 7.70\%, which understates the exact
nominal requirement).
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