Problem:
A bank consultant suggested that Sheila and Ed offer one of their best customers, Shanghai Winters, a 3.5% interest rate rather than the 8.0% going rate on a $70,000 five-year note receivable. Sheila and Ed would like you to explain the rationale behind the recommendation. Ed would also like to know what the interest rate would be for his worst customer.
Consider the following information:
Based on economic reports you estimate that adding a 2.5% inflation rate over the next 5 years would sufficiently account for inflation.
XYZ's credit department assigns a credit rate percentage to each potential borrower based on their past credit history. The credit rate range is on a scale from 1%-5%. A 1% credit rate is assigned to a potential borrower with excellent credit and 5% is assigned to a potential borrower with the worst possible credit.
Based on past history, XYZ does not charge an additional profit percentage to its best customers because the company anticipates making a healthy profit from sales of the product. However, for problem customers, the company will charge an additional 1.5% to the loan.
The interest, or discount rate, is made up of three components: profit, credit risk, and inflation expectations.