Transcript Essentials of Finance - University of South Florida

The Cost of Money
What is the cost of money, and how is it
determined?
What factors affect interest rates?
What is a yield curve?
How do government actions and business
activity affect interest rates?
How does the level of interest rates affect the
values of stocks and bonds?
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
Realized Returns
Dollar return
Dollar income + Capital gains
Yield

Beginning value
Beginning value

Dollar income + (Ending value- Beginning value)
Beginning value
$3 + ($12 - $10) $5


 0.50  50.0%
$10
$10
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Cost of Money
Interest rates are based on:
Production Opportunities—greater production
opportunities, greater demand for funds
Time Preference for Consumption—individuals save
less if they have a great need for current
consumption
Risk—investors demand higher returns for riskier
investments
Inflation—investors save to increase their ability to
purchase in the future
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Interest Rates—Levels
Function of supply and demand
Interest
Rate, r
S1
8.5
7.0
D2
D1
Dollars
Interest rates fluctuate continuously
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Interest Rates—Determinants
Return (r)
Risk Premium = RP
rRF
r = rRF + RP
Risk-Free Return = rRF
0
Risk
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Interest Rates—Determinants
r = rRF
= [r* + IP]
r*
IP
+
RP
+ [DRP + LP + MRP]
= real risk-free rate
= inflation premium
= rRF
DRP = default risk premium
LP
= liquidity (marketability) premium
MRP = maturity risk premium
= RP
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Premiums Added to r* for
Different Types of Debt
Short-Term Treasury: only IP for S-T
inflation
Long-Term 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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Term Structure of Interest Rates—
Yield Curve
Rate
(Yield)
Upward sloping
Flat
Downward sloping
Maturity
Short-Term Bonds
Long-Term Bonds
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U.S. Treasury Bond Interest Rates
on Different Dates
Interest Rate
(%)
16
14
March 1980
12
10
8
6
July 2006
4
July 2003
2
0
1
Short Term
5
Intermediate Term
10
15
Y ears to
20 Maturity
Long Term
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Term Structure of Interest Rates
Explanations for the shape of a yield curve:



Expectations Theory—slope of yield curve is
the same as expected interest movements
Liquidity Preference Theory—investors prefer
more liquidity to less
Market Segmentation Theory—market is
segmented by maturity (LT or ST)
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Interest Rates
Other Factors that Influence Interest Rates
Federal Reserve Policy
Federal Deficits
Foreign Trade Balance
Business Activity
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Interest Rates
Interest Rate Levels and Stock Prices:
highly correlated
Interest Rates and Business Decisions:
a firm’s decisions concerning what types
of financing should be used for investments in assets is based on forecasts of
future interest rates
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Forecasting Interest Rates
Exp Infl
Year
Each Yr
Avg Inflation Per Yr, IPt
20x1
1%
= 1%/1
= 1%
20x2
5%
= (1%+5%)/2
= 3%
20x3
6%
= (1%+5%+6%)/3
= 4%
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Forecasting Interest Rates
If the real risk-free rate, r*, is 3 percent, then the
forecasted yields on bonds will be:
Bond Type
r*
+
IPt
= Nominal Rate, rRF
1-year bond
3%
+
1%
=
4%
2-year bond
3%
+
3%
=
6%
3-year bond
3%
+
4%
=
7%
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Forecasting Interest Rates
Year
r*
20x1
20x2
20x3
3%
3%
3%
Expected
Annual Infl
Rate on a
1-Year Bond
1%
5%
6%
4%
8%
9%
Bond Type
Average of 1-Year Rates
rRF
1-year bond
1-year
2-year bond
3-year bond
2-year
4%/1
(4% + 8%)/1
8%)/2
(4% + 8% + 9%)/2
9%)/3
4.0%
6.0%
8.0%
8.5%
7.0%
=
=
=
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The Cost of Money as a
Determinant of Value



CF1
CF2
CFn
Value of an Asset 


1
2
(1  r)
(1  rr)
(1  r)
r
rn

CF t = expected cash flow in Period t
r = required rate of return
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Answers to Questions
What is the cost of money, and how is it
determined?
 The interest rate that lenders charge borrowers.
Determined by the supply of funds and the
demand for those funds.
What factors affect interest rates?
 Production opportunities, time preferences for
consumption, risk, inflation.
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Answers to Questions
What is a yield curve?
 A snapshot of the relationship between short-term
and long-term interest rates at a particular time.
How do government actions and business
activity affect interest rates?
 Government borrowing exerts pressure on the
demand for funds and may inflate interest rates.
How does the level of interest rates affect
the values of stocks and bonds?
 When rates increase in the financial markets, the
values of assets decrease.
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