Chapter 5
The Cost of
Money
(Interest
Rates)
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 1 of 25
Determinants of
Market Interest Rates
• Rate of return (interest) = k = Risk-free rate +
Premium for risk = kRF + RP
Return
Risk Premium = RP
kRF
k = kRF + RP
Risk-Free Return = kRF
0
Essentials of Managerial Finance by S. Besley & E. Brigham
Risk
Slide 2 of 25
Determinants of
Market Interest Rates
• Quoted rate = k = kRF
+
RP = [k* + IP]
+ [DRP + LP + MRP]
k*
IP
= real risk-free rate
= inflation premium
= kRF
DRP = default risk premium
LP
= liquidity (marketability) premium
MRP = maturity risk premium
Essentials of Managerial Finance by S. Besley & E. Brigham
= RP
Slide 3 of 25
The Term Structure of Interest Rates
Relationship between yields and
bond maturities
Yield
(%)
Upward sloping (normal)
Flat
Downward sloping (inverted)
Term to Maturity
(years)
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 4 of 25
The term structure of interest rates
Explanations for the shape of the yield curve
• 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.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 5 of 25
Interest rate Levels and Stock Prices
Effects on corporate profits
• 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
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 6 of 25
Interest rates and business decisions
A firm’s decision concerning what types of
financing should be used for investments in
assets is based on forecasts of future interest
rates
• 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
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 7 of 25
Self – test problems
Term structure of interest rates
• 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 longterm rather than short-term debt
– (a) TRUE
– (b) FALSE
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 8 of 25
Self – test problems
Term structure of interest rates
• And the right answer is…..
(a)
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 9 of 25
Self – test problems
Risk and return
• 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
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 10 of 25
Self – test problems
Risk and Return
• And the right answer is…..
(c)
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 11 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 oneyear 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 12 of 25
Problem 2-7 Solution
Given:
One-year bond yield
Two-year bond yield
k*3.0%
MRP
10.0%
11.5%
0.0%
10.0%  X%

 11.5%
bond yield
2
Two - year
One-year rate
X %  2(11.5%)  10.0%  13.0%
In Year 2
krf  3%  inf l1  10%
krf  3%  inf l2  13%
Essentials of Managerial Finance by S. Besley & E. Brigham
inf l1  7%
inf l2  10%
Slide 13 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 14 of 25
Problem 2-10 – Solution
Year One-Year Rate
2008
5%
2009
4%
2010
3%
Today = 1/1/05
3-yr yield = 6%
3(6%)  5%  4% 27%


 5.4%
yield (k 2009 )
5
5
5 - year bond
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 15 of 25