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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter Chapter 5 5 The Cost of Money (Interest Rates)
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

Jan 05, 2016

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Page 1: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25

Chapter Chapter 55

The Cost of Money

(Interest Rates)

Page 2: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 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

Page 3: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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

Page 4: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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

Page 5: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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

Page 6: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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

Page 7: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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

Page 8: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (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

Page 9: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (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

Page 10: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (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

Page 11: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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

Page 12: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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?

Page 13: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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

Page 14: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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?

Page 15: Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

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%