Effective Interest

(noun)

The amount of interest accrued per year after accounting for compounding.

Related Terms

Examples of Effective Interest in the following topics:

  • Comparing Interest Rates

    • Since interest compounds, the amount of interest actually accrued may be different than the nominal amount.
    • The last section went through one method for finding the amount of interest that actually accrues: the Effective Annual Rate (EAR).
    • It provides an annual interest rate that accounts for compounded interest during the year.
    • The nominal interest rate is approximately the sum of the real interest rate and inflation.
    • Discuss the differences between effective interest rates, real interest rates, and cost of capital

  • Calculating the Yield of a Single-Period Investment

    • However, since interest compounds, nominal APR is not a very accurate measure of the amount of interest you actually accrue.
    • To find the effective APR, the actual amount of interest you would accrue per year, we use the Effective Annual Rate, or EAR.
    • Interest usually compounds, so there is a difference between the nominal interest rate (e.g. monthly interest times 12) and the effective interest rate.
    • The Effective Annual Rate is the amount of interest actually accrued per year based on the APR. n is the number of compounding periods of APR per year.
    • The Annual Percentage Yield is a way or normalizing the nominal interest rate.

  • Free Cash Flow

    • Free cash flows = Net profit + Interest expense - Net Capital Expenditure (CAPEX) - Net change in Working Capital - Tax shield on Interest Expense
    • Where Net Capital Expenditure (CAPEX) = Capex - Depreciation & Amortization and Tax Shield = Net Interest Expense X Effective Tax Rate
    • Cash flows from operations = Earnings before Interest and Tax x (1-Tax rate) + Depreciation & Amortization - Changes in Working Capital

  • Factors External to the Firm

    • Factors such as corporate tax rate, interest rate fluctuation, and conditions of the economy and markets are external factors of the WACC.
    • Another external factor in determining WACC is changing interest rates.
    • It is in charge of moderating long-term interest rates.
    • This moderating of interest rates affects a company's WACC because of the importance of the risk-free rate in calculating cost of capital.

  • Calculating Values for Different Durations of Compounding Periods

    • Finding the Effective Annual Rate (EAR) accounts for compounding during the year, and is easily adjusted to different period durations.
    • But suppose you want to convert the interest rate into an annual rate.
    • The EAR can be found through the formula in where i is the nominal interest rate and n is the number of times the interest compounds per year (for continuous compounding, see ).
    • You can think of it as 2% interest accruing every quarter, but since the interest compounds, the amount of interest that actually accrues is slightly more than 8%.
    • The effective annual rate for interest that compounds more than once per year.

  • Individual Taxes

    • Most jurisdictions below the state level impose a tax on interests in real property (land, buildings, and permanent improvements).

  • Multi-Period Investment

    • The first concept of accruing (or earning) interest is called "simple interest. " Simple interest means that you earn interest only on the principal.
    • The second way of accruing interest is called "compound interest. " In this case, interest is paid at the end of each period based on the balance in the account.
    • Compound interest is named as such because the interest compounds: Interest is paid on interest.
    • Compare compound interest to simple interest.
    • You don't earn interest on interest you previously earned.

  • The Interest Rate Risk

    • Interest rates became volatile during the 1980s, forcing banks to become more concerned with interest-rate risk.
    • If the interest-rate sensitive liabilities exceed the interest-rate sensitive assets, then rising interest rates cause banks' profits to plummet, while falling interest rates cause banks' profits to increase.
    • If the interest-rate sensitive liabilities are less than interest-rate sensitive assets, subsequently, increasing interest rates cause banks' profits to soar, while declining interest rates cause banks' profits to plummet.
    • If the interest-rate sensitive liabilities equal the interest-rate sensitive assets, then fluctuating interest rates do not affect bank profits.
    • If the interest rate rises, subsequently, the banks increase the interest rate on the loans.

  • Times-Interest-Earned Ratio

    • Times Interest Earned ratio (EBIT or EBITDA divided by total interest payable) measures a company's ability to honor its debt payments.
    • Times interest earned (TIE), or interest coverage ratio, is a measure of a company's ability to honor its debt payments.
    • Interest Charges = Traditionally "charges" refers to interest expense found on the income statement.
    • Times Interest Earned or Interest Coverage is a great tool when measuring a company's ability to meet its debt obligations.
    • When the interest coverage ratio is smaller than 1, the company is not generating enough cash from its operations EBIT to meet its interest obligations.

  • Calculating Present Value

    • But first, you must determine whether the type of interest is simple or compound interest.
    • If the interest is simple interest, you plug the numbers into the simple interest formula.
    • Simple interest is pretty rare.
    • Simple interest is when interest is only paid on the amount you originally invested (the principal).
    • You don't earn interest on interest you previously earned.