The inflation component preserves the purchasing power of money (Ross, Westerfield, & Jaffe, 2005). Based on economic reports, a 2.5% inflation rate over the next 5 years would sufficiently account for inflation.
The second component of the interest rate is the credit risk. The interest rate offered to customers with poor credit worthiness is higher to compensate for the higher risk of lending to them (Weston, Besley, & Brigham, 1996). Based on the credit rate range established by the credit department, the best customer would be assigned a 1% credit rate.
The last component of the interest rate is the profit component. This component is the profit from financing activities of XYZ. Since Shanghai Winters is one of the best customers, this component is not applicable to it.
Notice that this interest rate is higher than the 8.0% going rate on a $70,000 five-year note receivable. The higher rate is to compensate for the credit risk of extending credit to such a customer. Also built inside the 8.0% is the profit component, which has not been charged to the best customers. ...Show more