Question

Professor Wendy Smith has been offered the following​ opportunity: A law firm would like to retain her for an upfront payment of $49,000.In​ return, for the next year the firm would have access to eight hours of her time every month. As an alternative payment​ arrangement, the firm would pay Professor​ Smith's hourly rate for the eight hours each month. ​ Smith's rate is $545 per hour and her opportunity cost of capital is 15% per year. What does the IRR rule advise regarding the payment​ arrangement? (Hint: Find the monthly rate that will yield an effective annual rate of15%​.)What about the NPV​ rule?

My question is why we perceive the 15% cost of capital as the EAR but not APR?( why i cant perceive monthly interest rate as 15%/12=1.25%)

I am NOT asking for the answer for the whole question .Again , I am just asking WHY we perceive the 15% cost of capital as the EAR but not APR? Thank you very much

Answer 1

Answer : We percieve the 15% cost of capital as the Effective Annual Rate because Effective annual rate is computed after taking effect of compounding.Since in the given data its is all per month data is given and mentioned that 15% cost of capital is her oppounity cost which have calculated after taking into effect monthly compounding as the oppotunity cost of the person is what he losses.Therefore A person losses Effective Annual Rate (the rate which he would have effectively earned )and not the annual percentage rate which is annual rate qouted without compounding effect.Therefore we take 15% cost of capital as the EAR but not APR.

Hope you understood..Thankyou !!