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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

EFFECTIVE VERSUS NOMINAL INTEREST RATES Bank A pays 2% interest compounded annually on deposits, while Bank B pays 1.75% compounded daily.

  1. a. Based on the EAR (or EFF%), which bank should you use?
  2. b. Could your choice of banks be influenced by the fact that you might want to withdraw your funds during the year as opposed to at the end of the year? Assume that your funds must be left on deposit during an entire compounding period in order to receive any interest.

a.

Summary Introduction

To identify: The bank that offers better rate of interest.

Effective Annual Rate (EAR):

It is also known as the annual equivalent rate. It is the absolute rate of interest, which has earned on an investment. It occurs due to the frequent compounding over a period of time.

Explanation

Formula to calculate EAR is,

EAR=(1+INOMM)M1

Where,

  • EAR is for effective annual rate.
  • INOM is nominal interest rate.
  • M is compounding period.

Substitute 1

b.

Summary Introduction

To identify: The better option if fund is to be withdraw in between rather than at the end of the year.

Effective Annual Rate (EAR):

It is also known as the annual equivalent rate. It is the absolute rate of interest, which has earned on an investment. It occurs due to the frequent compounding over a period of time.

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