Effective Interest Rate (EIR)

 Is measured based on the kind of credit and its term,

particularly on short-term credit which includes:
Trade Credit- is a form of short-term financing common
to almost all businesses.
- Spontaneous credit from regular purchase of
goods.
Types of Trade Credit
* Open Accounts or Accounts Payable
* Notes Payable
* Trade Acceptance
Example

 D  360 
EIR    
 100  D  CP  DP 
 2%  360 
   
 (100  D)  (30  10) 
 2  360 
  
 98%  20 
 (2.04%)(18)
 36.72%
Effective Annual Interest Terms
18
 i 
EAR  1    1
 m
EAR  (1  .0204)  1
18

EAR  1.439  1
EAR  43.9%
 Line of Credit- maximum amount of loan that a borrower can
borrow from the bank. It requires
Compensating balance- amount of deposit, usually a
percentage of the loan obtained
- Should stay in the borrowers checking account
- Cannot be reduced until loan is fully paid

Effective Cost of Bank Loan = Interest

Loan - Compensating Balance

= P100,000 x 8%
P100,000-(20% x P100,000)
= P8,000
P100,000 – P20,000
= P8000
P80,000

= 10%
* Take note that the effective cost of the bank loan is
higher than the nominal interest rate of 8%
The EIR is equal to the nominal rate of 8% because
it is simple interest loan transaction. If the loan is
deducted in advance, the proceeds would be:
Proceeds = Loan – Interest
= P100,000 – P8,000
= P92,000
EIR = Interest
Proceeds
= P8,000
P92,000
= 8.696% or 8.7%
Alternatively, EIR on a discount loan can be computed as
follows:
EIR = Nominal Rate(%)
1- Nominal Rate (fraction or decimal)
= 8%
1 - .08
= .08
.92
= 8.696 or 8.7%
 Therefore, discounting has a higher EIR, than simple interest in
a loan transaction with interest paid at maturity date.
Yield to Maturity
 Is the interest rate which equates the present value of all
cash flows from the debt instrument with the current
value.
 Different ways to measure Yield to Maturity depending
on the type of instrument:
*A. For Simple Loan, YM = simple interest rate
YM = P11,000 – P10,000
P 10,000
= 10%
B. For Coupon Bond in which interest is paid annually and
the principal is paid in maturity period,
 ( FV  PP) 
EYM  1   
 n 
( FV  PP)
2
Where, 1 is the interest based on normal rate.
FV is the face value of the bond
PP is the purchase price of the bond
n is the number of years before maturity
Example:

A10%, 5-year bond of P1,000 was purchased for P980. What is

the yield to maturity.
 P1,000  P980  20
EYM  P100    100 
 

5 5

( P1000  P980) P1,980

2 2

( P100  4) P104
 
P990 P990

 10.50%
 At 10% At 11%
Present Value of Interest
100[1  (1  .10) 5 ] / .10
 379
100[1  (1  .11) 5 ] / .11
 370

Present Value of FV 10,000 /(1  .10) 5

 621
10,000 /(1  .11) 5
 593
Total 1000 963
Interpolation
At 10% FV  1,000
PP  980
Difference 20

At 10% PV  1,000
At 11% PV  963
Difference 37

20
 54%
37
Therefore the exact yield to maturity (YM) would be:
YM = Nominal Rate + .54% = 10.54%
C. Current Yield (CY) is the yearly coupon payment (C)
divided by the price of the security (P)
C
CY 
P
Bonds with a purchase price of P980 and a yearly
coupon payment of P100 will have a current yield of 10.20%.
Computed as:
P100
CY 
P980
 10.20%
Real Risk-Free Rate of Interest (k*)
- the interest rate that would exist on a riskless security if
zero inflation were expected.

The Real Risk-Free Rate is not static, it changes

overtime depending on economic conditions:
1. Rate of return corporations and other borrowers
can expect to earn on productive assets
2. People’s time preference for current versus future
consumption
Nominal or Quoted Risk-Free Rate of Interest ( k rf )
- is the interest rate that is adjusted for expected changes
in the price level so that it more accurately reflects the true
cost of borrowings.

Interest Rate and its Role in Finance

- Finance deals with funds which denotes money

- Changes in interest rates have implications for a multitude

of phenomena in the business and economic world.

- Central banks use interest rate and other monetary tools

to control money supply, demand for money, reserve
requirement and others.