Introduction to Finance

H O W T H I S C H A P T E R A P P L I E S TO M E . . .
It is nearly impossible to get through the day without seeing some reference to interest rates 
on saving or borrowing money. You may see interest rates being off ered on savings accounts 
by depository institutions, interest rates on new and used automobiles, and even the rate at 
which you could borrow for a loan to pay your tuition or to purchase a home. Your cost of 
borrowing will generally be higher when you are just starting your working career and your 
credit quality has not yet been established. Understanding the factors that determine the level 
of interest rates, hopefully, will help you make more informed decisions concerning when to 
spend, save, and borrow.
We all have been tempted by the advertisements for goods and services that suggest we should 
“buy now and pay for it later.” These advertisements are hoping that we will decide that, to us, 
the value of “more” current consumption is worth the added interest that we will have to pay 
on the funds that we must borrow to fi nance this consumption.
Sometimes, individuals like to consume more now, even though they don’t have the money 
to pay for this consumption. For example, you may see a pair of shoes in a store window “that 
you have to have right now.” Maybe you don’t currently have the money to pay for the shoes. 
Don’t despair; if you have a credit card, the credit card issuer may lend you the money to pay for 
the shoes. In return, you will have to pay back the amount borrowed plus interest on the loan.
You might also be considering making a current investment in your future by borrowing 
money to go to college. In this case, you hope that your current education will lead to an 
increase in your future earning power, out of which you will have to repay your student loan. 
When you purchased your shoes on credit, you decided to consume now and pay later for this 
current consumption. When you decide to invest in your education, you expect that future 
earnings will be larger, making it easier to repay the student loan. Businesses also borrow to 
make investments in inventory, plant, and equipment that will earn profi ts suffi
cient to pay 
interest, repay the amount borrowed, and provide returns to equity investors. In this chapter we 
focus on the cost or price of borrowing funds. An understanding of interest rates—what causes 
them to change and how they relate to changes in the economy—is of fundamental importance 
in the world of fi nance.