Essentials of Managerial Finance

1
Chapter 5 The Cost of Money (Interest Rates)
2
Determinants of Market Interest Rates

• Rate of return (interest) k Risk-free
  rate Premium for risk kRF RP

Risk Premium RP
k kRF RP
kRF
Risk-Free Return kRF

3
Determinants of Market Interest Rates

• Quoted rate k kRF RP k IP
  DRP LP MRP

k real risk-free rate IP inflation premium
k real risk-free rate IP inflation premium
kRF
DRP default risk premium LP liquidity
(marketability) premium MRP maturity risk
premium
DRP default risk premium LP liquidity
(marketability) premium MRP maturity risk
premium
RP


4
The Term Structure of Interest Rates
Relationship between yields and bond maturities
Upward sloping (normal)
Flat
Downward sloping (inverted)

5
The term structure of interest rates
Explanations for the shape of the yield curve

• Expectations theory
• The shape of the yield curve is based on
  expectations about inflation in the future, i.e.
  inflation increases gt yield curve upward sloping
• Liquidity preference theory
• Long-term bonds are considered less liquid than
  short-term bonds, i.e. long-term bonds must have
  higher yields to attract investors
• Market segmentation theory
• Borrowers and lenders prefer bonds with
  particular maturities.

6
Interest rate Levels and Stock Prices
Effects on corporate profits

• Interest is a cost to business, so interest rate
  changes have a direct impact on business profits
• Interest rates affect investment behavior, so
  when rates on bonds increase, money is taken out
  of the stock markets to invest in the bond
  markets gt general prices of stocks are pushed
  down and the prices of bonds are pushed up

7
Interest rates and business decisions
A firms decision concerning what types of
financing should be used for investments in
assets is based on forecasts of future interest
rates

• Suppose that interest rates are expected to fall
  over the next period, then the firm would borrow
  short-term and lock into lower long-term rates
  when the rates fall

8
Self test problems
Term structure of interest rates

• If you have information that a recession is
  ending, and the economy is about to enter a boom,
  and your firm needs to borrow money, it should
  probably issue long-term rather than short-term
  debt
• (a) TRUE
• (b) FALSE

9
Self test problems
Term structure of interest rates

• And the right answer is..
• (a)

10
Self test problems
Risk and return

• Your uncle would like to restrict his interest
  rate risk and his default risk, but he still
  would like to invest in corporate bonds. Which of
  the possible bonds listed below best satisfies
  your uncles criteria?
• (a) AAA bond with 10 years to maturity
• (b) BBB bond with 10 years to maturity
• (c) AAA bond with 5 years to maturity
• (d) BBB bond with 5 years to maturity

11
Self test problems
Risk and Return

• And the right answer is..
• (c)

12
Exam type problems

• Problem 2-7 (page 82)
• Suppose the annual yield on a two-year Treasury
  bond is 11.5 percent, while that on a one-year
  bond is 10 percent k is 3 percent, and the
  maturity risk premium is zero.
• Using the expectations theory, forecast the
  interest rate on a one-year bond during the
  second year
• What is the expected inflation rate in Year 1?
  Year 2?

13
Problem 2-7 Solution
Given One-year bond yield 10.0 Two-year bond
yield 11.5 k 3.0 MRP 0.0

One-year rate In Year 2
14
Exam type problems

• Problem 2-10 (page 82)
• Today is January 1, 2005, and according to the
  results of a recent survey, investors expect the
  annual interest rates for the years 2008 2010
  to be

Year One-Year Rate 2008 5 2009 4 2010 3

• The rates given here include the risk-free rate,
  kRF , and appropriate risk premiums. Today a
  three year bond that is, a bond that matures
  on December 31, 2007, has an interest rate equal
  to 6. What is the yield to maturity for bonds
  that mature at the end of 2008, 2009 and 2010?

15
Problem 2-10 Solution
Year One-Year Rate 2008 5 2009 4 2010 3
Today 1/1/05 3-yr yield 6