Interest Rates

Dr. Vinodh Madhavan

 Cost of Money

 Factors affecting cost of money

 Production Opportunities
 Time preferences for consumption
 Risk
 Inflation

 Interest rate is a function of

 Producers’ expected rate of return on invested capital
 Savers’ time preference for current vs. future consumption
 Riskiness of loan
 Expected future rate of inflation
 Determination of Interest Rates
r = r* + IP + DRP + LP + MRP

r represents any nominal rate

r* represents the “real” risk-free rate of interest.

IP inflation premium

DRP is default risk premium

LP is liquidity premium

MRP and maturity risk premium

Premiums Added to r* for Different Types of
Debt

IP MRP DRP LP
S-T Treasury 

L-T Treasury  

S-T Corporate   

L-T Corporate    
 Yield Curve and the Term Structure of
Interest Rates
Interest

 Term structure – relationship 14%

March 1980

between interest rates (or yields) 12%

and maturities. 10%

8%
February 2000

 The yield curve is a graph of the 6%

term structure. 4%
October 2008
2%

 The October 2008 Treasury yield 0%

0 10 20 30
curve is shown at the right. Years to Maturity
 Constructing the Yield Curve: Inflation
 Step 1 – Find the average expected inflation rate over Years 1 to N:

 INFL t
IPN  t 1
N

 For the inflation premium to be precise and theoretically sound, it

should be the geometric average of inflationary expectations for the
residual life of the maturity.
 Constructing the Yield Curve: Inflation
Assume inflation is expected to be 5% next year, 6% the following
year, and 8% thereafter.

IP1  5% /1  5.00%
IP10  [5%  6%  8%(8)]/10  7.50%
IP20  [5%  6%  8%(18)]/ 20  7.75%

Any financial security should earn atleast the estimated inflation

premium, for the holder of such a security to keep up with his/her
original purchasing power at the time of investment.
 Constructing Yield Curve: Maturity Risk
 Step 2 : Find the appropriate maturity risk premium (MRP).

 For instance, the following simplistic equation could be a

mathematical representation of a security’s appropriate maturity
risk premium.

MRPt = 0.1% (t – 1)
 Constructing Yield Curve: Maturity Risk
Using the given equation:

MRP1  0.1%  (1  1)  0.0%

MPP10  0.1%  (10  1)  0.9%
MRP20  0.1%  (20  1)  1.9%
Notice that since the above equation is linear, the maturity risk
premium is increasing as the time to maturity increases, as it
should be.
Constructing Yield Curve: Construct Yield Curve
Step 3 – Adding the premiums to r*.
rRF, t = r* + IPt + MRPt
Assume r* = 3%,

rRF, 1  3%  5.0%  0.0%  8.0%

rRF , 10  3%  7.5%  0.9%  11.4%
rRF , 20  3%  7.75%  1.9%  12.65%
 Hypothetical Yield Curve
 An upward sloping yield
Interest curve.
Rate (%)
15 Maturity risk premium
 Upward slope due to an
increase in inflationary
10 Inflation premium expectations and increasing
maturity risk premium over
time.
5

Real risk-free rate

Years to
0 Maturity
1 10 20
 Treasury vs. Corporate Yield Curves
 Corporate yield curves are higher than that of Treasury
securities, though not necessarily parallel to the Treasury curve.

 The spread between corporate and Treasury yield curves widens

as the corporate bond rating decreases.

 Bonds rated AAA (Aaa) are judged to have less default risk than
bonds rated AA (Aa), while AA bonds are less risky than bonds
rated A and so on.
 Illustrating the Relationship Between
Corporate and Treasury Yield Curves

Interest
Rate (%)
15

BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%

Years to
0 Maturity
0 1 5 10 15 20
 Pure Expectations Hypothesis
 The PEH contends that the shape of the yield curve depends on
investor’s expectations about future interest rates.

 If interest rates are expected to increase, long-term rates will

be higher than short-term rates, and vice-versa.

 Thus, the yield curve can slope up, down, or even bow.
 Assumptions of the PEH
 Assumes that the maturity risk premium for Treasury securities
is zero.

 Long-term rates are an average of current and future short-term

rates.

 If PEH is correct, you can use the yield curve to “back out”
expected future short-term interest rates.
An Example: Observed Treasury Rates and
the PEH

Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%

If PEH holds, what does the market expect will be the interest rate on
one-year securities, one year from now? Three-year securities, two
years from now?
 One-Year Forward Rate
6.0% x%

0 1 2

6.2%
(1.062)2 = (1.060) (1 + X)
1.12784/1.060 = (1 + X)
6.4004% = X
 PEH says that one-year securities will yield 6.4004%, one year from
now.

 Notice, if an arithmetic average is used, the answer is still very close.

Solve: 6.2% =
(6.0% + X)/2, and the result will be 6.4%.
Three-Year Security, Two Years from Now
6.2% x%

0 1 2 3 4 5

6.5%

(1.065)5 = (1.062)2 (1 + X)3

1.37009/1.12784 = (1 + X)3
6.7005% = X

 PEH says that three-year securities will yield 6.7005%, two years
from now.
 Conclusions about PEH
 Some would argue that the MRP ≠ 0, and hence the PEH is incorrect.

 Most evidence supports the general view that lenders prefer short-
term securities, and view long-term securities as riskier.

 Hence, investors demand a premium to persuade them to hold

long-term securities (i.e., MRP > 0).
 Macroeconomic Factors That Influence
Interest Rate Levels
 Monetary policy

 Federal budget deficits or surpluses

 International factors / foreign trade deficit

 Level of business activity

Bond Valuation
 What is value?
 The term value is used in different senses in the finance literature.

 Liquidation Value vs. Going Concern Value

 Liquidation value is the amount that can be realized if part of

a firm or the firm as a whole is sold separately from the
operating organization to which it belongs.

 Going concern value is the amount that can be realized

should the firm be sold as a continuing operating entity.
 What is value?
 Book Value vs. Market Value

 Book Value of an asset is the carrying value of any asset, which is

calculated as the original cost-base of the asset minus the accumulated
depreciation accounted for the specific asset

 Book value for a firm as a whole is the difference between book value of
all assets of the reporting entity minus the book value of all liabilities of
the reporting entity (SHE = TA-TL)

 Market Value of an asset is the price at which the asset trades in the
market place. Almost always, market value of equity is higher than its
book (par) value. However this is not the case with bonds.
 What is value?

 Market Value vs. Intrinsic Value

 The intrinsic value of an asset is the present value of all cash

flows expected from the asset, discounted at a rate of return
that is appropriate for the risk associated with the security.

 Intrinsic value is economic value of an asset

 Should the market be reasonably efficient, the market price of

an asset should hover around its intrinsic value.
 Bonds
 A bond is a contract wherein a borrower promises to pay interest
and principal on specific dates to the holders of the bond.

 In India, the principal issuers of bonds are

 Central Government (Treasury Bonds)
 State Government (State Government Bonds)
 Public Sector Undertakings (PSU Bonds)
 Private sector companies (Corporate Bonds)

 Bonds issued by PSUs and private sector companies, generally

have a maturity ranging from 1 year to 15 years, and they pay
coupons on a semi-annual basis, unless stated otherwise.
 Key Features of a Bond
 Par value – face amount of the bond, which is paid at maturity
(assume $1,000 if not specified).

 Coupon interest rate – stated interest rate (generally fixed) paid

by the issuer.
 Multiply by par value to get dollar payment of interest.

 Maturity date – years until the bond must be repaid.

 Issue date – when the bond was issued.

 Yield to maturity – rate of return earned on a bond held until

maturity (also called the “promised yield”).
 The Bond Pricing Equation

 1 
1 -
 (1  R) T  FV
Bond Value  C  
 (1  R)
T
 R
 
 Pure Discount Bonds
 Make no periodic interest payments (coupon rate = 0%)

 The entire yield to maturity comes from the difference between the
purchase price and the par value.

 Cannot sell for more than par value

 Sometimes called zeroes, deep discount bonds, or original issue

discount bonds (OIDs)

 Treasury Bills and principal-only Treasury strips are good examples of

zeroes.
 Pure Discount Bonds
Information needed for valuing pure discount bonds:
 Time to maturity (T) = Maturity date - today’s date
 Face value (F)
 Discount rate (r)

$0 $0 $0 $F

0 1 2 T 1 T

Present value of a pure discount bond at time 0:

FV
PV 
(1  R)T
 Pure Discount Bond: Example
Find the value of a 30-year zero-coupon bond with a $1,000 par
value and a YTM of 6%.

$0 $0 $0 $1,000 $0 $0 1,

0 1 2 9 30


0 1 2 29 30

FV $1,000
PV    $174.11
(1  R) T
(1.06) 30
 Level Coupon Bonds
 Make periodic coupon payments in addition to the maturity value

 The payments are equal each period. Therefore, the bond is just a
combination of an annuity and a terminal (maturity) value.

 Coupon payments are typically semiannual.

 Consols

 Not all bonds have a final maturity.

 British consols pay a set amount (i.e., coupon) every period forever.

 These are examples of a perpetuity.

C
PV 
R
 Bond Concepts

 Bond prices and market interest rates move in opposite directions.

 When coupon rate = YTM, price = par value

 When coupon rate > YTM, price > par value (premium bond)

 When coupon rate < YTM, price < par value (discount bond)
 YTM with Annual Coupons
 Consider a bond with a 10% annual coupon rate, 15 years to
maturity, and a par value of $1,000. The current price is $928.09.

 Will the yield be more or less than 10%?

 YTM = {C+(MV – Price )/n}/{0.4*MV + 0.6*Price}

 Effect of a Call Provision
 Allows issuer to refund the bond issue if rates decline (helps the
issuer, but hurts the investor).

 Borrowers are willing to pay more, and lenders require more, for
callable bonds.

 Most bonds have a deferred call and a declining call premium.

 What is a sinking fund?
 Provision to pay off a loan over its life rather than all at maturity.

 Similar to amortization on a term loan.

 Reduces risk to investor, shortens average maturity.

 But not good for investors if rates decline after issuance.

 How are sinking funds executed?
 Call x% of the issue at par, for sinking fund purposes.

 Likely to be used if rd is below the coupon rate and the bond sells at
a premium.

 Buy bonds in the open market.

 Likely to be used if rd is above the coupon rate and the bond sells at
a discount.
 Definitions

Annualcouponpayment
Current yield (CY) 
Currentprice

Changein price
Capital gains yield (CGY) 
Beginning price

Expected total return  YTM   Expected   Expected

 CY   CGY 

7-38
 Other Types (Features) of Bonds
 Convertible bond – may be exchanged for common stock of the
firm, at the holder’s option.
 Warrant – long-term option to buy a stated number of shares of
common stock at a specified price.
 Putable bond – allows holder to sell the bond back to the company
prior to maturity.
 Income bond – pays interest only when income is earned by the
firm.
 Indexed bond – interest rate paid is based upon the rate of inflation.
Stock Valuation
 The Present Value of Common Stocks
 The value of any asset is the present value of its expected future cash
flows.
 Stock ownership produces cash flows from:
 Dividends
 Capital Gains
 Valuation of Different Types of Stocks
 Zero Growth
 Constant Growth
 Differential Growth
 Case 1: Zero Growth
 Assume that dividends will remain at the same level forever

Div 1  Div 2  Div 3  

 Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:

Div 1 Div 2 Div 3

P0    
(1  R) (1  R) (1  R)
1 2 3

Div
P0 
R
 Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g, forever, i.e.,

Div 1  Div 0 (1  g )
Div 2  Div 1 (1  g )  Div 0 (1  g ) 2
Div 3  Div 2 (1  g )  Div 0 (1  g )3
.
Since future cash flows grow at a constant rate forever, the value
of a constant growth stock is.. the present value of a growing
perpetuity:

Div 1
P0 
Rg
 Case 3: Differential Growth
 Assume that dividends will grow at different rates in the foreseeable
future and then will grow at a constant rate thereafter.

 To value a Differential Growth Stock, we need to:

 Estimate future dividends in the foreseeable future.

 Estimate the future stock price when the stock becomes a Constant
Growth Stock (case 2).

 Compute the total present value of the estimated future dividends

and future stock price at the appropriate discount rate.
 Case 3: Differential Growth
 Assume that dividends will grow at rate g1 for N years and
grow at rate g2 thereafter.

Div 1  Div 0 (1  g1 )
Div 2  Div 1 (1  g1 )  Div 0 (1  g1 ) 2
..
.
Div N  Div N 1 (1  g1 )  Div 0 (1  g1 ) N

Div N 1  Div N (1  g 2 )  Div 0 (1  g1 ) N (1  g 2 )

..
.
 Case 3: Differential Growth
Dividends will grow at rate g1 for N years and grow at rate
g2 thereafter

Div 0 (1  g1 ) Div 0 (1  g1 ) 2
…
0 1 2
Div N (1  g 2 )
Div 0 (1  g1 ) N  Div 0 (1  g1 ) N (1  g 2 )
… …
N N+1
Case 3: Differential Growth
We can value this as the sum of:
 an N-year annuity growing at rate g1

C  (1  g1 ) 
T
PA  1  T 
R  g1  (1  R) 
 plus the discounted value of a perpetuity growing at rate g2 that
starts in year N+1

 Div N 1 
 
 R  g2 
PB 
(1  R) N
 Case 3: Differential Growth
Consolidating gives:

 Div N 1 
 
C  (1  g1 )T   R  g 2 
P 1  T 

R  g1  (1  R)  (1  R) N

Or, we can “cash flow” it out.

 Estimates of Parameters

 The value of a firm depends upon its growth rate, g, and its
discount rate, R.

 Where does g come from?

g = Retention ratio × Return on retained earnings

 Stock Valuation Problems
1. Ezzel Corporation issued perpetual preferred stock with a 10%
annual dividend. The stock currently yields 8% and its par value
is $100.
a. What is the preferred stock’s value?
b. Should the interest rates in the broader economy increase,
and in-turn pull the preferred stock’s yield up to 12%, what is
the new market value of preferred stock?

2. Bruner Aeronautics has perpetual preferred stock outstanding

with a par value of $100. The stock pays a quarterly dividend of
$2 and its current price is $80.
a. What is its nominal annual rate of return?
b. What is its effective annual rate of return?
 Stock Valuation Problems
3. A stock is expected to pay a dividend of $0.50 one year hence,
and it should continue to grow at a constant rate of 7% a year. If
its required rate is 12%, what is the stock’s expected price 4
years from today?

4. Microtech Corporation is expanding rapidly and currently needs

to retain all of its earnings, hence it does not pay dividends.
However investors expect Microtech to begin paying dividends,
beginning with a dividend of $1.00 coming 3 years from today.
The dividend should grow rapidly –at the rate of 50% per year-
during years 4 and 5; but after year 5, growth should be a
constant 8% per year. If the required return on Microtech is
15%, what is the value of the stock today?
 Stock Valuation Problems
5. Mitts Cosmetics Co’s stock price is $58.88, and it recently paid a
$2.00 dividend. This dividend is expected to grow by 25% for the
next 3 years , then grow forever at a constant rate, g and r = 12%. At
what constant rate is the stock expected to grow after year 3?

6. Your broker offers to sell you some shares of Bahnsen and Co.
common stock that paid a dividend of $2.00 yesterday. Bahnsen’s
dividend is expected to grow at 5% per year for the next 3 years.
a. If you buy the stock, plan to hold it for 3 years, and then sell it at
$34.73, what is the most you should be willing to pay for this
stock, assuming a discount rate of 12%.
b. If the holding period is 5 years rather than 3 years, would this
affect the value of stock today?
 Stock Valuation Problems
7. Taussing Technologies Corporation (TTC) has been growing at a
rate of 20% per year in recent years. This same growth rate is
expected to last for another 2 years, and then decline to 6%. If
current dividend (at t=0) is $1.60, and if discount rate is 10%
a. What is TTC’s stock worth today?
b. What are the expected dividend yields and capital gains yield
for years of supernormal growth (years 1 and 2)?
c. Should TTC’s supernormal growth rate last for 5 years rather
than 2 years, calculate the price of TTC’s stock today, and the
dividend yield and capital gains yield for the years of
supernormal growth.
 Stock Valuation Problems
 Q7 continued: d: Suppose TTC recently introduced a new line of products
that has been wildly successfully. On the basis of this success and anticipated
future success, the following free cash flows (in millions) were projected.
Year FCF Year FCF
1 5.5 6 88.8
2 12.1 7 107.5
3 23.8 8 128.9
4 44.1 9 147.1
5 69.0 10 161.3
 After the tenth year, TTC’s financial planners anticipate FCF to grow by 6%
every year. Further, this new project has reduced overall enterprise risk,
which in-turn has reduced enterprise cost of capital to 9%.
 Assuming (a) market value of TTC’s debt to be 1200 million, and (b) 20
million common shares outstanding (no preferred shares), what is value of
TTC’s stock as of today (use corporate valuation model).
 Stock Valuation Problems

8. A company’s annual dividends have increased from $1.25 for

1990 to $1.75 for 1995.
a. What is the average annual rate of growth of dividends from
1990 to 1995?
b. If an investor’s required rate of return is 12%, how much
should he be willing to pay for a share of the company’s stock
at the beginning of 1996, assuming that the rate of growth
will continue at the same rate as during the preceding five
years?
c. What would be the required rate of growth of the annual
dividends for the stock to be worth a selling price of $40 per
share at the beginning of 1996?
 Stock Valuation Problems
9. Barrett Industries invests a large sum of money in R&D, as a result,
it retains and reinvests all of its earnings. In other words, Barrett
does not pay any dividends and it has no plans to pay any dividends
in the near future. A major pension fund is interested in purchasing
Barrett’s stock. The pension fund manager has estimated Free Cash
Flows for the next four years as follows: $3 million, $6 million, $10
million, and $15 million. After the fourth year, Barrett’s cash flow is
projected to grow at a constant rate of 7%.
I. If Barrett’s enterprise cost of capital is 12%, what is the firm’s
value as of today?
II. What is the estimate of Barrett’s price per share, if Barrett
Industries has (a) cumulative debt and preferred stock totaling
$60 million and (b) 10 million outstanding common shares
 Stock Valuation Problems
10. Assume that today is December 31st, 2008 and that the following
information (estimation) applies to Vermeil Airlines:
• After-tax operating income for 2009 is expected to be $500
million
• Depreciation expense for 2009 is $100 million
• Capital Expenditures for 2009 are expected to be $200 million
• No change in net working capital
• FCFs are expected to grow at a constant rate of 6% going forward
• Enterprise cost of capital is 10%
• Market Value of company’s debt is $3 billion.
• Number of common shares outstanding: 200 million
• What should be the company’s stock price today?