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?
1

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
2
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
3
Interest Rates—Levels
Function of supply and demand
Interest
Rate, r
S1
8.5
7.0
D2
D1
Dollars
Interest rates fluctuate continuously
4
Interest Rates—Determinants
Return (r)
Risk Premium = RP
rRF
r = rRF + RP
Risk-Free Return = rRF
0
Risk
5
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
6
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
7
Term Structure of Interest Rates—
Yield Curve
Rate
(Yield)
Upward sloping
Flat
Downward sloping
Maturity
Short-Term Bonds
Long-Term Bonds
8
U.S. Treasury Bond Interest Rates
on Different Dates
Interest R ate
(%)
16
14
March 1980
12
10
8
6
July 2006
4
July 2003
2
0
1
Short Term
5
Inter mediate Term
10
15
Years 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)
10
Interest Rates
Other Factors that Influence Interest Rates
Federal Reserve Policy
Federal Deficits
Foreign Trade Balance
Business Activity
11
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
12
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.
17
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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