Question

Define and describe nominal and real interest rates. What impact do interest rates have on the cost of financing a purchase? What is the discount formula?

Answer 1

1 a. Real Interest Rate- A real interest rate is one that is adjusted to remove the effects of inflation, thus reflecting the real cost of funds to the borrower and the real yield to the lender or investor.The real interest rate gives lenders and investors an idea of the real rate they receive after factoring in inflation. Real interest rte gives a better idea of whether the purchasing power is increasing or decreasing.

1. b. Nominal Interest Rate- A nominal interest rate, refers to an interest rate that does not factor out inflation. It is taken before inflation is taken into account. One of the disadvantage of nominal interest rate is that it does not adjust for the inflation rate.This is the interest rate that is charged by banks and institutions to the customers.

2. Interest rates have the below impact on financing purchases:

a. The lower the interest rate, the more willing people are to borrow money to make big purchases.

b. When interest rates rise banks charge more for business loans which means a larger part of the earnings would be needed to pay interest on loans which ultimately decreases the profits.

c. When interest rates are rising, both businesses and consumers will reduce spending. Thus causing earnings to fall and stock prices to drop.

d. During period of high interest rates businesses can invest their excess cash in interest-bearing accounts to make more money. When rates are low, businesses can use their cash for new equipment and plant improvements.

3. The Discount Formula is as below:

Discount is a kind of reduction or deduction in the cost price of a product. It is mostly used in consumer transactions, where people are provided with discounts on various products

Discount = List Price- Selling Price (Listed Price minus the Selling Price)

Discount Percentage = Discount/List Price*100 (Discount divided by List Price multiplied by 100)