Solution: The real rate of interest measures the return earned on savings, and it represents the cost of borrowing to finance capital goods. The real rate of interest is determined by the interaction between firms that invest in capital projects and the rate of return businesses can expect to earn on investments in capital goods, and individuals’ time preference for consumption. Graphically, it is that point when the desired saving level equals the desired level of investment in the economy. Interest Rates: How does the nominal rate of interest vary over time? LO 7 Solution: The nominal rate is the rate that we observe in the marketplace. it is determined by both the real rate as well expected inflation. Therefore, the nominal rate will fluctuate according the changes in the real rate as well as changes in expected inflation. Interest Rates: What is the Fisher equation, and how is it used? LO 7 Solution: The Fisher equation is the expected, not the reported or actual, annualized change in commodity prices (∆Pe). It is used to protect the buying power from changes in inflation, and it is incorporated into a loan contract by adding it to the real interest rate that would exist in the absence of inflation. Interest Rates: Imagine you borrow $500 from your roommate, agreeing to pay her back the $500 plus 7 percent interest in one year. Assume inflation over the life of the contract is expected to be 4.25 percent. What is the total amount you will have to pay her back in a year? What percentage of the interest payment is the result of the real rate of interest? LO 7
Solution: The real rate of interest measures the return earned on savings, and it represents the cost of borrowing to finance capital goods. The real rate of interest is determined by the interaction between firms that invest in capital projects and the rate of return businesses can expect to earn on investments in capital goods, and individuals’ time preference for consumption. Graphically, it is that point when the desired saving level equals the desired level of investment in the economy. Interest Rates: How does the nominal rate of interest vary over time? LO 7 Solution: The nominal rate is the rate that we observe in the marketplace. it is determined by both the real rate as well expected inflation. Therefore, the nominal rate will fluctuate according the changes in the real rate as well as changes in expected inflation. Interest Rates: What is the Fisher equation, and how is it used? LO 7 Solution: The Fisher equation is the expected, not the reported or actual, annualized change in commodity prices (∆Pe). It is used to protect the buying power from changes in inflation, and it is incorporated into a loan contract by adding it to the real interest rate that would exist in the absence of inflation. Interest Rates: Imagine you borrow $500 from your roommate, agreeing to pay her back the $500 plus 7 percent interest in one year. Assume inflation over the life of the contract is expected to be 4.25 percent. What is the total amount you will have to pay her back in a year? What percentage of the interest payment is the result of the real rate of interest? LO 7
Solution-manual-for-Fundamentals-of-Corporate-Finance-2nd-edition-by-Robert-Parrino.docx