Chapter 5
Interest Rates
I. Chapter Outline
The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides
are referenced in bold. Alternative Examples to selected textbook examples are also available in the
PowerPoint Lecture Slides and are also referenced in bold.
5.1 Interest Rate Quotes and Adjustments (Slides 6–7)
• The Effective Annual Rate (Slide 6)
– Adjusting the Discount Rate to Different Time Periods (Slide 7)
– General Equation for Discount Rate period Conversion (Slide 7)
• Example 5.1 Valuing Monthly Cash Flows (Slides 8–9)
• Example 5.2 Converting the APR to a Discount Rate (Slides 16–17)
• PowerPoint Alternative Example 5.2 (Slides 18–20)
5.2 Application: Discount Rates and Loans (Slides 21–24)
– Computing Loan Payments (Slide 21–23)
5.3 The Determinants of Interest Rates (Slide 27–28)
• Global Financial Crisis: Teaser Rates and Subprime Loans
• Inflation and Real Versus Nominal Rates (Slide 27)
• Example 5.4 Calculating the Real Interest Rate (Slides 29–30)
• PowerPoint Alternative Example 5.4 (Slides 31–32)
• Figure 5.2 Term Structure of Risk-Free U.S. Interest Rates, November 2006, 2007, and 2008
(Slide 38)
• Example 5.5 Using the Term Structure to Compute Present Values (Slides 40–41)
• PowerPoint Alternative Example 5.5 (Slides 42–43)
• The Yield Curve and the Economy (Slides 44–45)
– Interest Rate Determination
Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition 19
• Common Mistake: Using the Annuity Formula When Discount Rates Vary by Maturity
• Figure 5.3 Short-Term versus Long-Term U.S. Interest Rates and Recessions (Slide 46)
5.4 Risk and Taxes (Slide 53)
54)
• Example 5.7 Discounting Risky Cash Flows (Slides 55–56)
5.5 The Opportunity Cost of Capital (Slide 62)
• Common Mistake: States Dig a $3 Trillion Hold by Discounting at the Wrong Rate
Chapter 5 Appendix Continuous Rates and Cash Flows (Slides 65–70)
II. Learning Objectives
5-2 Given an effective annual rate, compute the n-period effective annual rate.
5-4 Describe the relation between nominal and real rates of interest.
5-6 Describe the effect of higher interest rates on net present values in the economy.
5-8 Discuss the determinants of the shape of the yield curve.
5-10 Given the other two, compute the third: after-tax interest rate, tax rate, and before-tax interest
rate.
20 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition
III. Chapter Overview
Chapter 4 introduced the time value of money using risk-free rates of interest. Chapter 5 begins the
5.1 Interest Rate Quotes and Adjustments
This section discusses effective annual rate, annual percentage rate, and the rate per compounding
5.2 Application: Discount Rates and Loans
5.3 The Determinants of Interest Rates
Factors that may influence the willingness of individuals to borrow and lend are inflation, government
policy, and expectations of future growth. The text uses the multiplicative form of the Fisher
equation:
Rearranging Equation 5.4 allows us to solve for the real rate of interest and an approximation:
The text also emphasizes that when interest rates are low, more positive NPV projects are in the
economy. The Federal Reserve and other central banks use this information to stimulate investment or
to reduce investment when the economy is “overheating,” which can lead to inflation. There is also a
discussion of Federal Reserve actions in response to the 2008 Financial Crisis.
5.4 Risk and Taxes
Two additional factors are important in determining interest rates: risk and taxes. All interest rates on
5.5 The Opportunity Cost of Capital
In summary, interest rates vary based on quoting conventions, the term of the investment, and risk.
Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition 21
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 5 have spreadsheet versions of the problems available: 2, 3, 10,
18, 19, 21, 22, 29, 30, 31, and 32.