BUS202: Principles of Finance

Variables, such as compounding, inflation, and the cost of capital must be considered before comparing interest rates.

LEARNING OBJECTIVE

• Discuss the differences between effective interest rates, real interest rates, and cost of capital

KEY TAKEAWAYS

Key Points

• A nominal interest rate that compounds has a different effective rate (EAR), because interest is accrued on interest.
• The Fisher Equation approximates the amount of interest accrued after accounting for inflation.
• A company will theoretically only invest if the expected return is higher than their cost of capital, even if the return has a high nominal value.

Key Terms

• inflation: An increase in the general level of prices or in the cost of living.

The amount of interest you would have to pay on a loan or would earn on an investment is clearly an important consideration when making any financial decisions. However, it is not enough to simply compare the nominal values of two interest rates to see which is higher.

Effective Interest Rates

The reason why the nominal interest rate is only part of the story is due to compounding. Since interest compounds, the amount of interest actually accrued may be different than the nominal amount. The last section went through one method for finding the amount of interest that actually accrues: the Effective Annual Rate (EAR).

The EAR is a calculation that account for interest that compounds more than one time per year. It provides an annual interest rate that accounts for compounded interest during the year. If two investments are otherwise identical, you would naturally pick the one with the higher EAR, even if the nominal rate is lower.

Real Interest Rates

Interest rates are charged for a number of reasons, but one is to ensure that the creditor lowers his or her exposure to inflation. Inflation causes a nominal amount of money in the present to have less purchasing power in the future. Expected inflation rates are an integral part of determining whether or not an interest rate is high enough for the creditor.

The Fisher Equation is a simple way of determining the real interest rate, or the interest rate accrued after accounting for inflation. To find the real interest rate, simply subtract the expected inflation rate from the nominal interest rate.

$i \approx r+\pi$

Fisher Equation: The nominal interest rate is approximately the sum of the real interest rate and inflation.

For example, suppose you have the option of choosing to invest in two companies. Company 1 will pay you 5% per year, but is in a country with an expected inflation rate of 4% per year. Company 2 will only pay 3% per year, but is in a country with an expected inflation of 1% per year. By the Fisher Equation, the real interest rates are 1% and 2% for Company 1 and Company 2, respectively. Thus, Company 2 is the better investment, even though Company 1 pays a higher nominal interest rate.

Cost of Capital

Another major consideration is whether or not the interest rate is higher than your cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. Many companies have a standard cost of capital that they use to determine whether or not an investment is worthwhile.

In theory, a company will never make an investment if the expected return on the investment is less than their cost of capital. Even if a 10% annual return sounds really nice, a company with a 13% cost of capital will not make that investment.