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Learning OutcomesChapter 5

Describe the cost of money and factors that affect the cost of money.

Describe how interest rates are determined.

Describe a yield curve and discuss how a yield curve might be used to determine future interest rates.

Discuss how government actions and general business activity affect interest rates.

Describe how changes in interest rates (returns) affect the values of stocks and bonds.

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Realized Returns (Yields)

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Factors that Affect the Cost of Money

Production opportunities

Time preferences for consumption

Risk

Inflation

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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

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Interest Rate Levels

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Determinants of Market Interest Rates

r = Quoted or nominal rate rRF = The quoted risk-free rateRP = Risk premium RP = DRP = LP = MRPDRP = Default risk premium LP = Liquidity premiumMRP = Maturity risk premium

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= real risk-free rate.T-Bond rate if no inflation;2% to 4%.

r*

= any nominal rate.r

= Rate on T-securities—risk-free.rRF

“Real” versus “Nominal” Rates

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IP = Inflation premiumDRP = Default risk premiumLP = Liquidity premiumMRP = Maturity risk premium

Premiums Added to r* for Different Types of Debt

Short-Term (S-T) Treasury: only IP for S-T inflation

Long-Term (L-T) Treasury: IP for L-T inflation, MRP

Short-Term corporate: Short-Term IP, DRP, LP

Long-Term corporate: IP, DRP, MRP, LP

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The Term Structure of Interest Rates

Term structure: the relationship between interest rates (or yields) and maturities

A graph of the term structure is called the yield curve.

U.S. Treasury Bond Interest Rates on Different Dates

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U.S. Treasury Bond Interest Rates on Different Dates (Yield Curves)

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Three Explanations for the Shape of the Yield Curve

Liquidity Preference Theory

Expectations Theory

Market Segmentation Theory

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Liquidity Preference Theory

Lenders prefer S-T securities because they are less subject to interest rate risk and are thus more easily bought or sold in the market.

Thus, S-T rates should be low, and the yield curve should be slope upward.

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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. Thus, the yield curve can slope up OR down.

Step 1: Find the average expected inflation rate over years 1 to N:

Calculating Interest Rates Expectations Theory

IP

INFLt = 1

N

N n =

t

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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 taxes).

Example:

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MRP1 = 0.1% x 0 = 0.0%

MRP10 = 0.1% x 9 = 0.9%

MRP20 = 0.1% x 19 = 1.9%

Calculating Interest Rates Expectations Theory:

Step 2: Find MRP based on this equation: MRPt = 0.1% (t - 1)

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Step 3: Add the IPs and MRPs to r*:rRFt = r* + IPt + MRPt

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: rRF20 = 3% + 7.75%+ 1.9%= 12.7%

Calculating Interest Rates Expectations Theory:

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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)

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Other Factors That Influence Interest Rate Levels

Federal Reserve Policy

Federal deficits

International Business (Foreign Trade Balance)

Business Activity

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Interest Rate Levels and Stock Prices

The higher the rate of interest, the lower a firm’s profits

Interest rates affect the level of economic activity, and economic activity affects corporate profits

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The Cost of Money as a Determinant of Value