Cost of Money

8/8/2019 Cost of Money

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1Copyright 2010, Prepared by Amyn Wahid. All rights reserved.


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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?

Required Dividend Capitalreturn yield gain= + .

Cost of Money


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What four factors affect the cost

of money?

Production opportunitiesTime preferences for consumption

Risk

Expected inflation


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Copyright 2010, Prepared by Amyn Wahid. All rights reserved.

k = k* + IP + DRP + LP + MRP.

Here:k = Required rate of return on a

debt security.k* = Real risk-free rate.IP = Inflation premium.

DRP = Default risk premium.LP = Liquidity premium.

MRP = Maturity risk premium.


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The Real Risk-Free Rate of Interest, k*

k* is defined as the interest rate that would existon a risk less security if no inflation wereexpected. e.g U.S Treasury securities in an

inflation-free world.The risk free rate changes over time dependingon economic conditions especially

The rate of return expected by the investorsPeoples time preference for current versus futureconsumption.

The risk free rate is difficult to estimate but hasfluctuate in the range of 1 to 5 % in recent years.


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Inflation Premium (IP)

IP as discussed before has to be adjusted becauseinflation has a major impact on the interest rates.To illustrate, suppose you invested $1,000 in treasurybills that matures in a year and pays a 5% interest rate.At the end of the year you receive $1,050, Nowsuppose the inflation rate was 10% and it affected allitems equally. If gas had cost $1 gallon at thebeginning of the year it would cost $1.10 at the end of the year. Therefore, you would have bought 1000gallons at the beginning of the year but only 955gallons at the end of the year. In real terms you wouldbe worse off.Therefore, if k*= 2.5%,and if IP = 2.7%, then the quotedinterest rate will be 5.2%


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Default Risk Premium (DRP)

DRP compensates for the risk of default on theloan. It reflects the possibility that the issuer willnot pay interest or principal at the stated timeand in the stated amount.The greater the default risk, the higher theinterest rate.

Treasure securities have no default risk. Hencethe difference between the quoted interest rateon a T-bond and that on a corporate bond withsimilar maturity, liquidity, and other features isthe default risk premium(DRP).


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Liquidity Premium (LP)

LP is a premium charged by lenders toreflect the fact that some securities cannotbe easily converted into cash on a shortnotice at a reasonable price.LP is very low for treasury securities andfor securities issued by large and strongfirms. However, its relatively high onsecurities issued by small firms.LP is normally higher for long termcorporate securities than the short termones but not always


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Maturity Risk Premium (MRP)

MRP is a premium charged by lenders to reflect therisk of price declines of securities at the time of maturity.

Long term bonds and even treasury bonds areexposed to a significant risk of price declines.MRP , like the others, is difficult to estimate. Itsfluctuates and varies somewhat over time. It riseswhen interest rates are volatile and uncertain.However it falls when interest rates are relativelystable.

Note. Although long term bonds are heavilyexposed to interest rate risk, short term bills areheavily exposed to reinvestment rate risk .


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What is the term structure of interestrates? What is a yield curve?

Term structure : the relationship between long andshort term rates. It is important to understand how boththe rates relate to each other and what causes shift intheir relative positions. The term structure is importantto both borrowers and investors.

Borrower:- whether to borrow by issuing long or short term

debtInvestor:- when to buy long or short term bonds

A graph of the term structure is called the yield curve .


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Example of a Treasury Yield Curve

0

5

10

15

10 20 30

Years to Maturity

InterestRate (%)

1 yr 6.3%5 yr 6.7%

10 yr 6.5%30 yr 6.2%

Yield Curve(May 2000)


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Yield Curve

Historically, in most years long termrates have been above short term

rates, so the yield curve slopesupward.For this reason:-

Upward sloping curve is normal yield curveDownward sloping curve is abnormal curveNeither upward nor downward curve ishumped


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Lets look at whatdetermines the shape

of the yield curve

Lets look at whatdetermines the shape

of the yield curve


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What determines the shape of the yield curve ?

The shape of the yield curve depends onall the factors affecting the interest ratei.e. expected inflation, default risk,liquidity and maturity.However the two keyfactors pointed out are as follows:-

expectations about future inflationperceptions about the relative riskiness of securitieswith different maturities.

The yield curve for treasury bonds arelower then the corporate bonds primarilybecause of MRP, DRP and LP ( as discussedbefore)


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Hypothetical Treasury Yield Curve

0

5

10

15

1 10 20

Years to Maturity

InterestRate (%) 1 yr .0%

10 yr 11.4%

20 yr 12.65%

Real risk-free rate

Inflation premium

Maturity risk premium


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What factors can explainthe shape of this yield curve?

This constructed yield curve is upwardsloping.

This is due to increasing expectedinflation and an increasing maturity riskpremium.When the inflation is expected to

decrease the yield curve would bedownward sloping. (Refer to pg 1 0)


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What kind of relationship existsbetween the Treasury yield curve andthe yield curves for corporate issues?

Corporate yield curves are higher thanthat of the Treasury bond. However,corporate yield curves are not neces-sarily parallel to the Treasury curve.The spread between a corporate yieldcurve and the Treasury curve is larger the longer the maturity as explainedby the data. (Refer to pg 1 1)


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Example of Yield Curves

US YieldCurve


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Example of Yield Curves


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The Shape of the Yield Curve

Shape of the yield curve depends

on the investors expectationsabout future interest rates.If interest rates are expected toincrease, L-T rates will be higher than S-T rates and vice versa.Thus, the yield curve can slope upor down.


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PEH assumes that MRP = 0.

Long-term rates are an average of

current and future short-term rates.For example, if 10 y ear bonds yield 9%today, and if 5 y ear bonds are expectedto yield 7.5% 10 tears from now, then

investors would expect to earn 9% for 10 years and 7.5% for 5 years, for anaverage return of .5%

The Pure ExpectationsHypothesis (PEH)


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Some argue that the PEH isnt correct,because securities of different

maturities have different risk.General view (supported by mostevidence) is that lenders prefer S-Tsecurities, and view L-T securities as

riskier.Thus, investors demand a MRP to getthem to hold L-T securities (i.e., MRP> 0).

Conclusions about PEH


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Interest Rates & Business Decisions

Choosing between the option of long term or short term rates is a dilemma for both borrower and lender.Its difficult to predict future inters levels but it iseasy to predict interest rates will fluctuate theyalways have and they always will.

A sound and optimal financial policy calls for using short and long term debt as per requirement and in the right balance. Also,for positioning the firm to survive in any futureinterest rate environment.


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Cost of Money

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