Chapter 5

The Cost of
Money
(Interest Rates)
 Realized Returns
(Yields)
The dollar return on a financial asset can be
stated as follows:
Dollar return = (Dollar income) + (Capital
gains)
= (Dollar income) + (Ending value -
Beginning value)
Yields = Dollar return/Beginning value
 Factors That Affect
The Cost of Money
Four factors that affect the cost of
money
Production opportunities
Is it worth investing in new assets?
Time preferences for consumption
Now or later?
Risk
How likely is it that this investment wont
pan out?
Expected inflation
How much will prices increase over time?
 The Cost of
Money
What do we call the price, or cost, of debt
capital?
The Interest Rate

What do we call the price, or cost, of

equity capital?
Return on Equity =Dividends + Capital
Gains
 Interest Rate
Levels
Interest Rates as a Function of Supply and
Demand
Market A: Low-Risk Securities Market B:High-Risk Securities
Interest Rate, rA Interest Rate, rB
% S1
%
S1

rB = 12

rA = 10
8
D1 D1
D2

0 0
Dollars Dollars
 Real versus
Nominal Rates
r* = real risk-free rate.
Typically 2% to 4%
Tbillforshortterm
Tbondforlongterm
r = any nominal rate = quoted rate

rRF = Risk-free rate on T-securities

 The Determinants
of
Market Interest
Rates
r = Quoted or nominal rate
r* = Real risk-free rate (r-star)
IP = Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
 The Determinants
of
Market Interest
Rates
QuotedInterestRate=r
r=Riskfreeinterestrate+riskpremium
r=rRF+RP
r=rRF+[DRP+LP+MRP]
r=[r*+IP]+[DRP+LP+MRP]
 The Determinants
of
Market Interest
Rates
NominalInterestRate=r=[r*+IP]+[DRP+LP+MRP]

IP = average rate of inflation expected in

future
DRP = risk that a borrower will default on a
loan (difference between the T-bond interest
rate and a corporate bond with same features)
LP = premium if asset cannot be converted to
cash quickly and at close to the original cost (2
5%)
MRP = the interest rate risk associated with
longer maturity periods (usually 1 2%)
 Determinants of
Market Interest
Rates
Quoted Risk-Free Rate = r = r + DRP + LP +
RF
MRP
r = Quoted or nominal rate
rRF = Real risk-free rate plus a
premium for expected inflation
or rRF = r* + IP
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
 Premiums Added to k*
for
Different Types of Debt
IP = Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk
premium
Short-Term (S-T) Treasury: only IP for S-T inflation
Long-Term (L-T) Treasury:
IP for L-T inflation plus MRP
Short-Term corporate: Short-Term IP, DRP, LP
Long-Term corporate: IP, DRP, MRP, LP
 The Term Structure
of
Interest Rates
Term structure: the relationship between
interest rates (or yields) and maturities. It
is important to corporate treasurers, who
must decide whether to buy long or short
term bonds.
A graph of the term structure is called the
yield curve.
 U.S. Treasury Bond:
Interest Rates on
Interest Rate (%)

Abnormal
16
Dates
Interest Rate
14 March 1980
Term to March July July
12 Maturity 1980 2000 2003
3 months 16.0% 6.1% 0.9%
10 1 year 14.0 6.1 1.0
5 years 13.5 6.2 2.3
8 10 years 12.8July 2000
6.1 3.3
Flat=horizontal 20 years 12.3 6.2 4.3
6

July 2003
4

2
Normal
0
1 5 10 20
Short Term Intermediate Term Long Term
 Three Explanations for
the
Shape of the Yield
Curve
Liquidity Preference Theory
Expectations Theory
Market Segmentation Theory
 Liquidity Preference
Theory
Lenders prefer to make short-term loans
rather than long-term loans.
Less interest-rate risk
More liquid
Lenders lend short-term funds at lower
rates
Says MRP > 0
Results in normal curve
 Expectations
Theory

Shape of curve depends on investors

expectations about future inflation rates.

If inflation is expected to increase, S-T rates

will be low, L-T rates high, and vice versa.

The yield curve can slope up OR down.

 Calculating Interest
Rates under
Expectations Theory

Step 1: Find the Inflation Premium, the average

expected inflation rate over years 1 to N
 Example:
Inflation for Year 1 is 5%.
Inflation for Year 2 is 6%.
Inflation for Year 3 and beyond is 8%.
r* = 3%
MRPt = 0.1% (t-1)
IP1 = 5%/ 1.0 = 5.00%
IP10 = [ 5 + 6 + 8(8)] / 10 = 7.5%
IP20 = [ 5 + 6 + 8(18)] / 20 = 7.75%
Must earn these IPs to break even vs. inflation;
these IPs would permit you to earn r* (before
 Calculating Interest Rates
under Expectations
Theory:
Step 2: Find MRP based on this
equation: MRPt = 0.1% (t - 1)

MRP1 = 0.1% x 0 = 0.0%

MRP10 = 0.1% x 9 = 0.9%

MRP20 = 0.1% x 19 = 1.9%

 Calculating Interest Rates
under Expectations
Theory:
Step 3: Add the IPs and MRPs to k*:
rRFt = r* + IPt + MRPt
rRF = Quoted market interest rate
on treasury securities.
Assume r* = 3%.
1-Yr: rRF1 = 3% + 5.0% + 0.0% = 8.0%
10-Yr: rRF10 = 3% + 7.5% + 0.9% =
11.4%
20-Yr: r = 3% + 7.75% + 1.9% =
 Yield Curve

Interest
Rate (%) Treasury
15 12.7%yield curve
11.4%
10 8.0%

Years to
0
0 1 5 10 15 20 maturity
 Market Segmentation
Theory
Borrowers and lenders have preferred
maturities
Slope of yield curve depends on supply
and demand for funds in both the L-T
and S-T markets
Curve could be flat, upward, or
downward sloping
 Other Factors that
Influence
Interest Rate Levels
Federal Reserve Policy
Controls money supply; impacts S-T interest rates
Federal Deficits
Larger federal deficits mean higher interest rates
Foreign Trade Balance
Larger trade deficits mean higher interest rates
Business Activity
Does the Federal Reserve need to stimulate
activity?
 Interest Rate
Levels
and Stock Prices
The higher the rate of interest, the lower a
firms profits
Interest rates affect the level of economic
activity . . . which affects corporate profits
If interest rates rise . . .
Investors turn to the bond market, sell
stock, and decrease stock prices
If interest rates decline . . .
Investors turn to the stock market, sell
bonds, and increase stock prices
Thank You