Company C is able to lend 5 000 eur to company D, however requires real interest yield 5%. What is the nominal interest rate, when the inflation equals to 3% and the tax rate is 19%. The result should be in % and rounded to 2 decimal places and comment your findings.
Question
Company C is able to lend 5 000 eur to company D, however requires real interest yield 5%. What is the nominal interest rate, when the inflation equals to 3% and the tax rate is 19%. The result should be in % and rounded to 2 decimal places and comment your findings.
Solution
To calculate the nominal interest rate, we can use the Fisher equation which states that the nominal interest rate is approximately equal to the sum of the real interest rate and the inflation rate. However, since the interest earned is also taxed, we need to adjust the real interest rate for tax.
Here are the steps:
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Adjust the real interest rate for tax: Real interest rate / (1 - Tax rate) = 5% / (1 - 19%) = 5% / 0.81 = 6.17%
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Add the inflation rate to the tax-adjusted real interest rate to get the nominal interest rate: = 6.17% + 3% = 9.17%
So, the nominal interest rate is approximately 9.17%.
This means that in order for Company C to achieve a real return of 5% on its loan to Company D, it would need to charge a nominal interest rate of approximately 9.17% when taking into account a 3% rate of inflation and a 19% tax rate. This is because the effects of inflation reduce the purchasing power of the money repaid, and tax further reduces the net return received.
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