Subject: Financial Management
Chapter: Two – Time Value of Money
Four tier structure for rates of interest in any economy
The starting point for any interest is the rate of inflation in the economy. Like for example, in India atpresent, it is around 3% now. We have seen earlier that interest is the compensation for loss of purchasing power of Indian Rupee. This loss is due to the phenomenon of “inflation”. We have alsolearnt that the banks would normally offer a rate of interest higher than the rate of inflation. Based onthis, let us construct a 4-tier system of interest rates. This would build up stage-wise rates of interesttill investment in a project.
– Rate of inflation, say 3%
– Rate of interest on investment say in bank depositRate of inflation + some compensation from the acceptor of deposits, say banks. = 3% + 4% = 7%,that is the lowest interest offered by a public sector bank now on fixed deposits. The exact premiumpaid to the depositor depends on the following:
The duration of the deposit – the longer the duration, the higher the premium and vice-versa. That is why the longer duration deposits would attract higher rates of interest and shorterduration deposits would have a lower rate of interest.
The need for deposits by the banking company for a specific period. The bank would offer ahigher rate for that period. Suppose a bank wants more deposits for six months rather thanone year. It will attract deposits for six months by offering higher rate of interest than themarket.
– What does the bank do with the deposits that it accepts? It gives loans. The rate of interest onloans becomes the next tier, Tier 3.
What are the factors that a bank would consider to determine its lending rate?
Average interest paid out on deposits and expensesMinimum expected profit from lending operationsDegree of risk in lending – specific to a borrower, depending upon his businessContinuing discussion on Tier 3, we see that the minimum rate of interest on loans would be 7% + 3%+ 1% = 11%. This is the lowest interest that any bank offers now in India on loans. There is a specificname for this rate. It is referred to as “Prime Lending Rate” or PLR. The bank would add further to thisrate depending upon risk etc., which is called “risk premium”
. This would again be different fromborrower to borrower.Why discuss about a loan here?Who takes loans in a big way from the banks? This does not refer to the housing or consumer loanstaken by salaried persons. Obviously, business enterprises. It is for investment in theirbusiness/projects. Hence the rate of return on a project would be the last Tier, called
Can you determine this rate? Yes and no. Yes, as you will be able to determine a formula for this. No,because, it is not always possible to evaluate risk associated with a project correctly. The formula is:Rate of interest on loans, say 11% + compensation for the additional risk taken by the project owner.For an outsider, it will not be possible to put a figure on this. This will depend upon the risk associatedwith the specific project.
This is the reason that for different activities, the same bank charges different rates of interest at thesame time. Similarly for different borrowers pursuing the same activity, the rates of interest would bedifferent as per perception of risk associated with them.
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