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Chapter 5 The Cost of Money (Interest Rates). Return. Risk. 0. Determinants of Market Interest Rates. Rate of return ( interest) = k = Risk-free rate+Premium for risk = k RF + RP. Risk Premium = RP. k= k RF + RP. k RF. Risk-Free Return = k RF. - PowerPoint PPT Presentation
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25
Chapter Chapter 55
The Cost of Money
(Interest Rates)
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 25
Determinants of Market Interest Rates
• Rate of return (interest) = k = Risk-free rate +
Premium for risk = kRF + RP
0 Risk
Return
kRF
Risk-Free Return = kRF
Risk Premium = RP k = kRF + RP
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 25
Determinants of Market Interest Rates
• Quoted rate = k = kRF + RP = [k* + IP]
+ [DRP + LP + MRP]
k* = real risk-free rateIP = inflation premiumDRP = default risk premiumLP = liquidity (marketability) premiumMRP = maturity risk premium
k* = real risk-free rateIP = inflation premium
= kRF
DRP = default risk premiumLP = liquidity (marketability) premiumMRP = maturity risk premium
= RP
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 25
The Term Structure of Interest RatesRelationship between yields and
bond maturities
Yield(%)
Term to Maturity(years)
Upward sloping (normal)
Downward sloping (inverted)
Flat
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 25
The term structure of interest rates
• Expectations theory
– The shape of the yield curve is based on expectations about
inflation in the future, i.e. inflation increases => 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.
Explanations for the shape of the yield curve
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 25
Interest rate Levels and Stock Prices
• 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 => general prices
of stocks are pushed down and the prices of bonds are
pushed up
Effects on corporate profits
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 25
Interest rates and business decisions
• 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
A firm’s decision concerning what types of financing should be used for investments in
assets is based on forecasts of future interest rates
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 25
Self – test problems
• 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
Term structure of interest rates
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 25
Self – test problems
• And the right answer is…..
(a)
Term structure of interest rates
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 25
Self – test problems
• 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 uncle’s 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
Risk and return
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 25
Self – test problems
• And the right answer is…..
(c)
Risk and Return
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 25
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?
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 25
Problem 2-7 Solution
Given:One-year bond yield 10.0%Two-year bond yield 11.5%k*3.0%MRP 0.0%
%5.112
%X%0.10
yield bond
year-Two
%0.13%0.10%)5.11(2% XOne-year rate
In Year 2
%10inf%3 1 lkrf%13inf%3 2 lkrf
%7inf 1 l%10inf 2 l
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 25
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?
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 25
Problem 2-10 – Solution
Year One-Year Rate2008 5%2009 4%2010 3%
%4.55
%27
5
%4%5%)6(3
)(k yield
bondyear -5
2009
Today = 1/1/053-yr yield = 6%