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Chapter 6: Q4Q (page 301)

Question:What are the components of an interest rate? Why is it important for accountants to understand these components?

Short Answer

Expert verified

The components of interest rate are pure rate on interest, the expected inflation rate of interest, and credit risk rate of interest. Accountants should have knowledge of these because it will help in choosing the best interest rate for a company.

Step by step solution

01

Step-by-Step solutionStep 1 Components of interest rate

The three components of interest rate are as follows:

Pure rate of interest: It is the amount charged by the lender in the case when there are no possibilities of default and expectation of inflation.

The expected inflation rate of interest: In the inflationary period lenders recognize that they are paid less in form of interest. So, to cover the loss they charge higher interest in a high inflation period.

Credit risk rate of interest: The business organizations can have low or a high credit risk depending upon their financial ability and profitability.

02

Importance to understand the components by the accountants

To identify the best appropriate interest rate for a given company, accountants of the company must have knowledge about the abovementioned components of the interest rate

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Most popular questions from this chapter

Question:The following are a number of values taken from compound interest tables involving the same number of periods and the same rate of interest. Indicate what each of these four values represents. (a) 6.71008. (c) .46319. (b) 2.15892. (d) 14.48656.

Chris Spear invested $15,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years? To what amount would the investment grow in 3 years if the fund earns 8% annual interest compounded semiannually?

Using the appropriate interest table, answer the following questions. (Each case is independent of the others). (a) What is the future value of 20 periodic payments of \(4,000 each made at the beginning of each period and compounded at 8%? (b) What is the present value of \)2,500 to be received at the beginning of each of 30 periods, discounted at 5% compound interest? (c) What is the future value of 15 deposits of \(2,000 each made at the beginning of each period and compounded at 10%? (Future value as of the end of the fifteenth period.) (d) What is the present value of six receipts of \)1,000 each received at the beginning of each period, discounted at 9% compounded interest?

Bo Newman will invest \(10,000 today in a fund that earns 5% annual interest. How many years will it take for the fund to grow to \)17,100?

Answer the following questions related to Dubois Inc.

(a) Dubois Inc. has \(600,000 to invest. The company is trying to decide between two alternative uses of the funds. One alternative provides \)80,000 at the end of each year for 12 years, and the other is to receive a single lump-sum payment of \(1,900,000 at the end of the 12 years. Which alternative should Dubois select? Assume the interest rate is constant over the entire investment.

(b) Dubois Inc. has completed the purchase of new Dell computers. The fair value of the equipment is \)824,150. The purchase agreement specifies an immediate down payment of \(200,000 and semiannual payments of \)76,952 beginning at the end of 6 months for 5 years. What is the interest rate, to the nearest percent, used in discounting this purchase transaction?

(c) Dubois Inc. loans money to John Kruk Corporation in the amount of \(800,000. Dubois accepts an 8% note due in 7 years with interest payable semiannually. After 2 years (and receipt of interest for 2 years), Dubois needs money and therefore sells the note to Chicago National Bank, which demands interest on the note of 10% compounded semiannually. What is the amount Dubois will receive on the sale of the note?

(d) Dubois Inc. wishes to accumulate \)1,300,000 by December 31, 2027, to retire bonds outstanding. The company deposits \(200,000 on December 31, 2017, which will earn interest at 10% compounded quarterly, to help in the retirement of this debt. In addition, the company wants to know how much should be deposited at the end of each quarter for 10 years to ensure that \)1,300,000 is available at the end of 2027. (The quarterly deposits will also earn at a rate of 10%, compounded quarterly.) (Round to even dollars.)
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