MAF101 Lecture Notes - Lecture 10: Cost Of Capital, Annual Percentage Rate, Nominal Interest Rate
14 Jun 2018
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TOPIC 6 Interest Rates- Lecture 10
*REVISION: THE IMPORTANCE OF INTEREST RATES
The time value of money is often measured by using an interest rate, which compensates
those who defer consumption until later (ie saving or investing) and imposes a charge on
those who wish to consume more now than their income allows (ie borrowing)
• The interest rate is basically the price of money. If you don't have money and you want
some, you have to borrow it from someone and pay them interest.
• A modern economy is intrinsically linked to interest rates, thus their importance in the
financial system and the economy
*INVESTORS’ REQUIRED RATE OF RETURN
The present value of an asset is found by discounting the estimated future cash flows back
to the present using the appropriate discount rate
• What is the “appropriate discount rate”?
• It is the minimum rate of return that an investor accepts from an investment to
compensate the investor for deferring current consumption in order to invest in financial
assets.
• This minimum rate of return is called the required rate of return (RRR)
• Investors use the required rate of return to decide whether making an investment is worth
the risk involved.
The RRR is subjective and varies from investor to investor. Required rate of return is the
return you desire on an investment before investing your money. For example, on a
particular share, you set a required rate of return of 15%. Another investor may set a
required rate of return of 10% for the same share. Your required rate of return determines
whether you should invest in this share or seek an alternative investment.
RRR represents the riskiness of the investment being made; the rate of return will reflect the
compensation that the investor receives for the risk borne.
*DIFFERENCES BETWEEN RRR AND EXPECTED RETURN
1. The RRR is the minimum return that an investor requires to make an investment in an
asset. The investment has not been made yet. The expected return is the return that the
investor expects to receive in the future once the investment is made.
2. The RRR is a subjective number and will be different for each investor. The expected
return is an estimate of the future and it can be calculated by using either formulas 4.2
(average of past returns) or 4.4 (assigning probabilities). There is no guarantee that the
E(R) will be received. (RISK).
*COMPONENTS OF THE REQUIRED RATE OF RETURN
The three components to an investors’ required rate of return are:
1. The expected rate of inflation
2. The real interest rate
3. The risk premium.
*COMPONENTS OF THE REQUIRED RATE OF RETURN: INFLATION
The rate of inflation is the annual percentage rate of change in the price level and is usually
measured by the consumer price index (CPI). Now in Australia the CPI is approx. 2%
Inflation reduces your purchasing power
If you deposit money in a bank account which earns 3% p.a. interest (the nominal interest
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Document Summary
If you don"t have money and you want: a modern economy is intrinsically linked to interest rates, thus their importance in the financial system and the economy. The rrr is subjective and varies from investor to investor. Required rate of return is the return you desire on an investment before investing your money. For example, on a particular share, you set a required rate of return of 15%. Another investor may set a required rate of return of 10% for the same share. Your required rate of return determines whether you should invest in this share or seek an alternative investment. Rrr represents the riskiness of the investment being made; the rate of return will reflect the compensation that the investor receives for the risk borne. *differences between rrr and expected return: the rrr is the minimum return that an investor requires to make an investment in an asset.
