Chapter 3: Cost of Investing in

Securities
Introduction:
Investment and speculation are not carried on
without cost. There are Direct Cost such as
Commission, interest paid on borrowed funds
and taxes, and Indirect cost such as Federal
estate and Gift taxes.
When an investor buy and sell securities, his
transaction cost involve direct costs stemming
from the transaction.
 Kinds of Direct Commission
Regular Commission
Commission structure would be reached by
negotiation.
Discount Brokers
It is best when an investor who makes his own
investment decision about what to buy or sell
and when to buy or sell.
Odd lot Brokers
It charge a fee as add lot differential for their
service, generally consists of orders for fewer
than 100 shares.
Transfer Taxes
 The government imposes tax on the seller of the
stocks, it varies according to the price of the stock
and the place of the residence of the seller.
Federal Personal Income Tax
- Calculating the tax liability is to derive the gross
income.
Gross Income
 Any income derive from salaries, interest, rent and
net capital gains.
Adjusted gross income
 Determined by deducting the allowable deduction
such as business expense, state and local taxes,
interest paid and charitable contributions.
In ADDITION, taxpayers are allowed to claim
Personal and Exemption for dependents.
- Let us assume that a married couple with two
children are attempting to calculate their taxable
income. The husband income earn P25,000 a
month.
 The income tax owed is based on taxable income
Adjusted Gross Income P XXX
Less:
Personal Deductions (P XX)
Excess Deductions ( XX) XXX
Taxable Income P XXX
 Determinants of Market Interest
Interest Rates (Nominal rates “r”)
Given on a security traded in the financial market
that is composed of risk free rate of interest plus
premium that reflects the risk of the security.
Wherein:
Rate of return = (Risk Free rate) + (Risk Premium)
The interest on debt can also be expressed in:
Rate of Return = RRF + RP
= RRF +(DRP+LP+MRP)
Risk Free Rate of Return (RRF)
 The rate that is the rate of return associated within an
economy that has a guaranteed outcome in the future.
Risk Premium (RP)
 Which is the return that exceeds the risk free rate of return
that represents the payment for the risk associated within an
investment.
Default Risk Premium (DRP)
 Which reflects the chance that borrower will not pay the
debt’s interest or principal on time.
Liquidity Premium (LP)
 Reflects the fact that some investments are more easily
converted into cash on short notice rather than other
securities.
Maturity Risk Premium (MRP)
 Which accounts for the fact that longer term bonds
experience grater price reactions to interest rates than do
short terms.
 The Nominal Risk Free Rate , Real risk free rate of
interest
Nominal Risk Free Rate
 It is the interest rate on a security that has absolutely no
risk at all
2 components of Nominal Risk Free Rate
1. Real risk free rate “r*”
 Defined as the interest rate that would be exist on a risk
free security if inflation is expected to be zero during the
investment period.
2. Inflation Premium
 A premium for expected inflation that investors add to
real risk free rate of return.
Hence:
Risk free rate (RRF)) =Real Risk Free (r*) + Inflation Premium (IP)
 The term Structure of Interest Rates
Term structure of interest rates
 The relationship between long term and short term
rates.
Two theories of structure of interest rates
1. Liquidity reference theory
 Lenders prefers short terms rather than long term.
2. Expectation theory
 Theory that shape depend on the investors about
future inflation rates.
Inflation expectation
 Represent the most important factor in the
determination of current interest rates.
To illustrate how inflation impacts the shape of
investment:
R treasury = Rrf + MRP or
= (r* + IP) + MRP
Inflation expectation may expected either:
1. Increase in the future
2. Decrease in the future.
Example:
Assume the real risk free rate ”r*” is 2% and that the
investor demand a o.1 percent maturity risk
premium for each year remaining until maturity on
any debts with a term maturity greater than 1 year,
with maximum value of 1%. Thus, if a t – bill
matures in 1 year, MRP = 0; but if t – bill mature in 5
years MRP = O.5 %, and if t – bills that matures in 10
years or longer will have MRP = 1%. Suppose
inflation expectation are as follows:
 Year Increasing inflation Decreasing inflation
1 year 1.0 % 5.0
2 years 1.8 4.2
3 years 2.0 4.0
4 years 2.4 3.4
5 years 2.8 3.2
After year 5 3.0 2.4

REAL RISK FREE INFLATION MATURITY RISK YIELD ON

MATURITY RATE ( r*) PREMIUMN ( IP) PREPMIUM RATE OF
(MRP) RETURN
1 YEAR
5 YEARS
10 YEARS
20 YEARS
 Other Factors that Influence Interest Rates
- Factors other than those discussed earlier both
general level of interest rates and the shape of
the yield curve.
- There are Four most important factors;
a. Federal Reserve Policy
 When money supply has a major effect on both
the level of economic activity and rate of the
inflation, and controls the money supply.
b. Federal Deficits
 If the government spends more than it takes in
from tax revenues.
c. International Business
 If business and individuals buys and sell to people
and firm in other countries.
 If the firm buy more than they sell, it is said to be
running foreign deficit.
d. Business Activity
- Business conditions influence interest rates.
• During periods of inflation, the general tendency is
towards higher interest rates.
• During recessions, both demand for money and the
rate of inflation tend to fall.
• During recession, short term rates decline more
sharply than do long terms.