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Copyright © 2010, Prepared by Amyn Wahid. All rights reserved.

m
Cost of Money

6 What do we call the price, or cost,


of debt capital?

The interest rate

6 What do we call the price, or cost,


of equity capital?
Required Dividend Capital
return = yield + gain .

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What four factors affect the cost
of money?

6 Production opportunities
6 Time preferences for consumption
6 Risk
6 Expected inflation

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The Determinants of
Market Interest Rates
Interest
Rate
Up!

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k = k* + IP + DRP + LP + MRP.

Here:
k = Required rate of return on a
debt security.
k* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium.

Copyright © 2010, Prepared by Amyn Wahid. All rights reserved.


The Real Risk-Free Rate of Interest, k*

6 k* is defined as the interest rate that would exist


on a risk less security if no inflation were
expected. e.g U.S Treasury securities in an
inflation-free world.
6 The risk free rate changes over time depending
on economic conditions especially
º The rate of return expected by the investors
º Peoples time preference for current versus future
consumption.
6 The risk free rate is difficult to estimate but has
fluctuate in the range of 1 to 5 % in recent years.

Copyright © 2010, Prepared by Amyn Wahid. All rights reserved.


The Nominal,or Quoted,
Risk-Free Rate of Interest, kRF

6 kRF = k* + IP, i.e. It¶s a risk free rate plus a


premium for expected inflation.
6 ³risk free rate´ without the modifier real
means quoted (nominal) rate.
6 The inflation premium is equal to the
average expected future inflation rate over
the life of the security, so IP is not
necessarily equal to the current inflation
rate. (discussed in the next slide)

Copyright © 2010, Prepared by Amyn Wahid. All rights reserved.


Inflation Premium (IP)

6 IP as discussed before has to be adjusted because


inflation has a major impact on the interest rates.
6 To illustrate, suppose you invested $1,000 in treasury
bills that matures in a year and pays a 5% interest rate.
At the end of the year you receive $1,050, Now
suppose the inflation rate was 10% and it affected all
items equally. If gas had cost $1 gallon at the
beginning of the year it would cost $1.10 at the end of
the year. Therefore, you would have bought 1000
gallons at the beginning of the year but only 955
gallons at the end of the year. In real terms you would
be worse off.
6 Therefore, if k*= 2.5%,and if IP = 2.7%, then the quoted
interest rate will be 5.2%
Copyright © 2010, Prepared by Amyn Wahid. All rights reserved.
Default Risk Premium (DRP)

6 DRP compensates for the risk of default on the


loan. It reflects the possibility that the issuer will
not pay interest or principal at the stated time
and in the stated amount.
6 The greater the default risk, the higher the
interest rate.
6 Treasure securities have no default risk. Hence
the difference between the quoted interest rate
on a T-bond and that on a corporate bond with
similar maturity, liquidity, and other features is
the default risk premium(DRP).

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Liquidity Premium (LP)

6 LP is a premium charged by lenders to


reflect the fact that some securities cannot
be easily converted into cash on a short
notice at a ³reasonable price´.
6 LP is very low for treasury securities and
for securities issued by large and strong
firms. However, its relatively high on
securities issued by small firms.
6 LP is normally higher for long term
corporate securities than the short term
ones but not always
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Maturity Risk Premium (MRP)

6 MRP is a premium charged by lenders to reflect the


risk of price declines of securities at the time of
maturity.
6 Long term bonds and even treasury bonds are
exposed to a significant risk of price declines.
6 MRP , like the others, is difficult to estimate. Its
fluctuates and varies somewhat over time. It rises
when interest rates are volatile and uncertain.
However it falls when interest rates are relatively
stable.
Note. Although long term bonds are heavily
exposed to interest rate risk, short term bills are
heavily exposed to §    § §
Copyright © 2010, Prepared by Amyn Wahid. All rights reserved. mm
Premiums Added to k* for
Different Types of Debt

6 ST Treasury:
kt = k* + IPt

6 LT Treasury:
kt = k* + IPt + MRPt

6 ST corporate:
kCt = k* + IPt + DRP+ LP

6 LT corporate:
kCt = k* + IPt + DRP+ LP + MRP

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What is the ³term structure of interest
rates´? What is a ³yield curve´?
6 Term structure: the relationship between long and
short term rates. It is important to understand how both
the rates relate to each other and what causes shift in
their relative positions. The term structure is important
to both borrowers and investors.
Borrower:- whether to borrow by issuing long or short term
debt

Investor:- when to buy long or short term bonds

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

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Example of a Treasury Yield Curve

Interest 1 yr 6.3%
Rate (%) 5 yr 6.7%
15
10 yr 6.5%
30 yr 6.2%
10 Yield Curve
(May 2000)
5

0 Years to Maturity
10 20 30

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Yield Curve

6 Historically, in most years long term


rates have been above short term
rates, so the yield curve slopes
upward.
6 For this reason:-
Upward sloping curve is ³normal´ yield curve
Downward sloping curve is ³abnormal´ curve
Neither upward nor downward curve is
humped

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Yield Curve

Interest Rates
erm to maturity ar h 1 80 August 1 ebruary 2000

m m
m  m
 
m  
m  
m  
 
m

Lets determine the shape of the yield curve for the


three time periods (Refer to pg 178)

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What determines the shape of
the yield curve ?

6 The shape of the yield curve depends on


all the factors affecting the interest rate
i.e. expected inflation, default risk,
liquidity and maturity.However the two key
factors pointed out are as follows:-
º expectations about future inflation
º perceptions about the relative riskiness of securities
with different maturities.

6 The yield curve for treasury bonds are


lower then the corporate bonds primarily
because of MRP, DRP and LP ( as discussed
before)
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Hypothetical Treasury Yield Curve

Interest
Rate (%) 1 yr .0%
15 Maturity risk premium 10 yr 11.4%
20 yr 12.65%
10 Inflation premium

Real risk-free rate


0 Years to Maturity
1 10 20

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What factors can explain
the shape of this yield curve?

6 This constructed yield curve is upward


sloping.
6 This is due to increasing expected
inflation and an increasing maturity risk
premium.
6 When the inflation is expected to
decrease the yield curve would be
downward sloping. (Refer to pg 1 0)

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What kind of relationship exists
between the Treasury yield curve and
the yield curves for corporate issues?

6 Corporate yield curves are higher than


that of the Treasury bond. However,
corporate yield curves are not neces-
sarily parallel to the Treasury curve.
6 The spread between a corporate yield
curve and the Treasury curve is larger
the longer the maturity as explained
by the data.(Refer to pg 1 1)

Copyright © 2010, Prepared by Amyn Wahid. All rights reserved. ??


Hypothetical Treasury and
Corporate Yield Curves

Interest
Rate (%)
15

BB-Rated
10
AAA-Rated
Treasury
6.0%
5 5.9% yield curve
5.2%

Years to
0
maturity
0 1 5 10 15 20
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Example of Yield Curves

½
Yield
Curve

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Example of Yield Curves

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The Shape of the Yield Curve

6 Shape of the yield curve depends


on the investors¶ expectations
about future interest rates.
6 If interest rates are expected to
increase, L-T rates will be higher
than S-T rates and vice versa.
Thus, the yield curve can slope up
or down.

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The Pure Expectations
Hypothesis (PEH)

6 PEH assumes that MRP = 0.


6 Long-term rates are an average of
current and future short-term rates.
6 For example, if m  §
  yield 9%
today, and if  §
  are expected
to yield 7.5% 10 tears from now, then
investors would expect to earn 9% for
10 years and 7.5% for 5 years, for an
average return of .5%

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Conclusions about PEH

6 Some argue that the PEH isn¶t correct,


because securities of different
maturities have different risk.
6 General view (supported by most
evidence) is that lenders prefer S-T
securities, and view L-T securities as
riskier.
6 Thus, investors demand a MRP to get
them to hold L-T securities (i.e., MRP
> 0).
Copyright © 2010, Prepared by Amyn Wahid. All rights reserved. ?
Interest Rates & Business Decisions

6 Choosing between the option of long term or


short term rates is a dilemma for both borrower
and lender.
6 Its difficult to predict future inters levels but it is
easy to predict interest rates will fluctuate they
always have and they always will.
6 A sound and optimal financial policy calls for
using short and long term debt as per
requirement and in the right balance. Also,for
positioning the firm to survive in any future
interest rate environment.
Copyright © 2010, Prepared by Amyn Wahid. All rights reserved. ?Î
Copyright © 2010, Prepared by Amyn Wahid. All rights reserved. 

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