Ethics Box 4 Chapter 4

Ethics Box 4 – Chapter 4

What’s the Equivalent Annual Rate for “Check into Cash”?

“Charge whatever price the market will bear”. Sounds like a recipe for maximizing profits, but how about maximizing shareholder wealth within ethical constraints? The case of “check into cash” or “payday loan” business is a fascinating ethical case example.

Living “paycheck to paycheck” is bad enough, but a few consumers apparently cannot even manage that. Rather than borrow from family, friends, or a pawnshop, these consumers increasingly turn to the payday loan shop. The lender will advance you $93 today so you will not have to wait for your $100 paycheck in two weeks. Then you can simply endorse your check and repay them two weeks from now. Sounds great, right? What is the effective (true) annual rate of the loan?

Using Equation 4.24 gives us the answer. First, let’s calculate the period interest rate. We determine the implied interest by subtracting the amount advanced from the amount paid back:

$7 = $100- $93

Then, we calculate the period interest rate (i/m) by dividing the interest amount by the amount borrowed:

i = $7/$93 = 0.075269 or 7.53%

Maybe 7.53% is a small price to pay for getting cast today—credit cards may charge 18-21% per year. However, that 7.53 % is not the nominal (stated) annual rate, but a period interest rate, and it has not been annualized. In Equation 4.24, the 0.0753 is (i/m), and m is 365/14—there are 26.07 of these 14-day periods per year. Now we can calculate EAR:

EAR= (1+0.0753)26.07–1

= 6.6371–1

= 5.6371

= 563.71%

Gulp. Double-gulp. How can this be going on, and why would anyone borrow at these astronomical rates? Because those shops are not classified as banks, they fall outside the state usury laws that prohibit super-high consumer loan interest rates. Consumers are likely unaware of the true interest rate. The ethical standard that is germane here is that of fairness. Ethicist Jeffrey Seglin of EmersonCollege notes that “legal” does not equate to “ethical” – and managers must consider impact of decisions on all constituencies, including customers. Behaving ethically includes avoiding deception. Some might counter that common needs are being met here, and this is just a case of “buyer beware.” However, ethics includesthree classes of fairness represented in this market offer:[1] freedom from misrepresentation, equal processing power (so that consumers have a basic competency level to process information without making mental errors), and equal bargaining power (which means neither party is richer than the other, constituting the basis for states’interest rate ceilings). An example to emulate here might be that of National Automobile Dealers Association (NADA), which rewrote its code of ethics to make itmore exact and comprehensive, asking dealers throughout the U.S to endorse it.

[1] Shefrin and Statman identify seven classes of fairness, based on the entitlements they provide, in their monograph, Ethics, Fairness, Efficiency, and Financial Markets

(Research Foundation of the Institute of Chartered Financial Analysts; 1992). These are freedom from coercion, freedom from misrepresentation, equal information, equal processing power, freedom from impulse, efficient prices, and equal bargaining power.