Page 473 - Introduction to Business

CHAPTER 13 Financial Management of the Firm and Investment Management 447

the next year. If people expect the general level of prices to increase by 3 percent over
the next year, the total interest rate charged by the lender will be

Nominal interest rate real interest rate expected inflation rate nominal interest rate The rate of
interest quoted in the financial news
In our example, the nominal interest rate would be 5 percent (2 percent real rate comprising the real rate of interest plus
3 percent inflation rate). The nominal interest rate is also known as the stated the expected inflation rate
interest rate, or simply the interest rate in the everyday financial news. The total stated interest rate The nominal
amount repaid by the borrower to the lender after one year equals $100 principal interest rate, also referred to simply as
the interest rate in the everyday
plus $5 interest (0.05 $100), or $105: $100 today is worth $105 in one year. If there financial news
were no inflation in the world, that is, if prices of goods and services remained con-
stant over time, the nominal interest rate would equal the real rate of interest. Also,
if our expectations about the future rate of inflation change, the nominal interest
rate will change. If we thought that inflation would rise at a 4 percent rate over the
next year in the previous example, then the nominal interest rate would be 6 per-
cent, and $100 today would be worth $106 in one year. Indeed, changes in interest
rates are usually due to changing inflation expectations.
So far, we have assumed that there is no risk that loan principal and interest
would not be repaid by the borrower. However, what if there were a risk that the
borrower would not pay the lender back? When firms borrow money from a bank,
the bank will assess the default risk of borrowing firms, which is the chance that the default risk The chance that a
firm will go bankrupt and be unable to pay back the loan. If the loan defaults, the borrower will go bankrupt and be
unable to pay back a debt
bank could lose its principal and promised interest. To compensate for potential
losses due to default risk, the bank (lender) will demand additional interest from
the firm (borrower). This added interest is known as a default risk premium. Con- default risk premium The added
tinuing our earlier example, let’s assume that the lender demands an additional interest rate charged by lenders due to
the default risk of the borrower
5 percent default risk premium from the borrower. Now the total interest rate
charged by the lender would be
Nominal interest rate real interest rate expected inflation rate
default risk premium

To “Keep America Rolling” after the events of 9/11, General Motors began offering zero percent
financing to car buyers. The low promotional interest rate triggered similar competitive financing
deals from other car makers, which stimulated car sales and production. While lowering costs for
customers, the low rates decreased the cash flows and profits of automobile manufacturers.

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