Chapter 5
The Cost of Money
(Interest Rates)
1
Learning Outcomes
Chapter 5
Describe the cost of money and factors that affect
the cost of money.
Describe how interest rates are determined.
Describe a yield curve and discuss how a yield curve
might be used to determine future interest rates.
Discuss how government actions and general
business activity affect interest rates.
Describe how changes in interest rates (returns)
affect the values of stocks and bonds.
2
Realized Returns (Yields)
3
Factors that Affect
the Cost of Money
Production opportunities
Time preferences for consumption
Risk
Inflation
4
The Cost of Money
What do we call the price, or cost, of debt
capital?
 The Interest Rate
What do we call the price, or cost, of equity
capital?
 Return on Equity = Dividends + Capital Gains
5
Interest Rate Levels
6
Determinants of Market Interest Rates
r
RP
DRP
MRP
= Quoted or nominal rate
= Risk premium
= Default risk premium
= Maturity risk premium
rRF = The quoted risk-free rate
RP = DRP = LP = MRP
LP = Liquidity premium
7
“Real” versus “Nominal” Rates
r*
= real risk-free rate.
T-Bond rate if no inflation;
2% to 4%.
r
= any nominal rate.
rRF
= Rate on T-securities—risk-free.
8
Premiums Added to r* for Different Types of Debt
IP
DRP
LP
MRP
=
=
=
=
Inflation premium
Default risk premium
Liquidity premium
Maturity risk premium
Short-Term (S-T) Treasury: only IP for S-T inflation
Long-Term (L-T) Treasury: IP for L-T inflation, MRP
Short-Term corporate: Short-Term IP, DRP, LP
Long-Term corporate: IP, DRP, MRP, LP
9
The Term Structure of Interest Rates
Term structure: the relationship between
interest rates (or yields) and maturities
A graph of the term structure is called the
yield curve.
10
U.S. Treasury Bond Interest Rates
on Different Dates
11
U.S. Treasury Bond Interest Rates
on Different Dates (Yield Curves)
12
Three Explanations for the
Shape of the Yield Curve
Liquidity Preference Theory
Expectations Theory
Market Segmentation Theory
13
Liquidity Preference Theory
Lenders prefer S-T securities because they
are less subject to interest rate risk and are
thus more easily bought or sold in the
market.
Thus, S-T rates should be low, and the yield
curve should be slope upward.
14
Expectations Theory
Shape of curve depends on investors’
expectations about future inflation rates.
If inflation is expected to increase, S-T rates
will be low, L-T rates high, and vice versa.
Thus, the yield curve can slope up OR down.
15
Calculating Interest Rates
Expectations Theory
Step 1: Find the average expected
inflation rate over years 1 to N:
IPn
=
N
∑ INFLt
t=1
N
16
Example:
Inflation for Year 1 is 5%.
Inflation for Year 2 is 6%.
Inflation for Year 3 and beyond is 8%.

r* = 3%
 MRPt = 0.1% (t-1)
IP1
IP10
IP20
= 5%/ 1.0 = 5.00%
= [ 5 + 6 + 8(8)] / 10 = 7.5%
= [ 5 + 6 + 8(18)] / 20 = 7.75%
Must earn these IPs to break even vs. inflation;
these IPs would permit you to earn r* (before taxes).
17
Calculating Interest Rates
Expectations Theory:
Step 2: Find MRP based on this equation:
MRPt = 0.1% (t - 1)
MRP1
= 0.1% x 0
= 0.0%
MRP10
= 0.1% x 9
= 0.9%
MRP20
= 0.1% x 19
= 1.9%
18
Calculating Interest Rates
Expectations Theory:
Step 3: Add the IPs and MRPs to r*:
rRFt = r* + IPt + MRPt
Assume r* = 3%.
1-Yr: rRF1 = 3% + 5.0% + 0.0% = 8.0%
10-Yr: rRF10 = 3% + 7.5% + 0.9% = 11.4%
20-Yr: rRF20 = 3% + 7.75% + 1.9% = 12.7%
19
Market Segmentation Theory
Borrowers and lenders have preferred
maturities
Slope of yield curve depends on supply and
demand for funds in both the L-T and S-T
markets (curve could be flat, upward, or
downward sloping)
20
Other Factors That Influence Interest
Rate Levels
Federal Reserve Policy
Federal deficits
International Business (Foreign Trade
Balance)
Business Activity
21
Interest Rate Levels and Stock Prices
The higher the rate of interest, the lower a
firm’s profits
Interest rates affect the level of economic
activity, and economic activity affects
corporate profits
22
The Cost of Money as a Determinant of
Value
23