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Chapter 5 Interest Rates. Chapter Outline 5.1 Interest Rate Quotes and Adjustments 5.2 Application: Discount Rates and Loans 5.3 The Determinants of Interest.

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Presentation on theme: "Chapter 5 Interest Rates. Chapter Outline 5.1 Interest Rate Quotes and Adjustments 5.2 Application: Discount Rates and Loans 5.3 The Determinants of Interest."— Presentation transcript:

1 Chapter 5 Interest Rates

2 Chapter Outline 5.1 Interest Rate Quotes and Adjustments 5.2 Application: Discount Rates and Loans 5.3 The Determinants of Interest Rates 5.4 The Opportunity Cost of Capital

3 Learning Objectives Understand the different ways interest rates are quoted Use quoted rates to calculate loan payments and balances Know how inflation, expectations, and risk combine to determine interest rates See the link between interest rates in the market and a firm’s opportunity cost of capital

4 5.1 Interest Rate Quotes and Adjustments Interest rates are the price of using money Effective Annual Rate (EAR) aka Annual Percentage Yield (APY) – The total amount of interest that will be earned at the end of one year

5 5.1 Interest Rate Quotes and Adjustments The Effective Annual Rate – With an EAR of 5%, a $100 investment grows to: $100  (1 + r) = $100  (1.05) = $105 – After two years it will grow to: $100  (1 + r) 2 = $100  (1.05) 2 = $110.25

6 5.1 Interest Rate Quotes and Adjustments Adjusting the Discount Rate to Different Time Periods – In general, by raising the interest rate factor (1 + r) to the appropriate power, we can compute an equivalent interest rate for a longer (or shorter) time period

7 5.1 Interest Rate Quotes and Adjustments Adjusting the Discount Rate to Different Time Periods (1 + r) 0.5 = (1.05) 0.5 = $1.0247, so a yearly rate of 5%, is equivalent to a rate of 2.47% every half of a year. $1  (1.0247) = $1.0247,  (1.0247) = $1.05 $1  (1.0247) 2 = $1.05 $1  (1.05) = $1.05

8 Equivalent n-Period Discount Rate = (1 + r) n – 1 (Eq. 5.1) 5.1 Interest Rate Quotes and Adjustments Adjusting the Discount Rate to Different Time Periods – A discount rate of r for one period can be converted to an equivalent discount rate for n periods: – When computing present or future values, you should adjust the discount rate to match the time period of the cash flows

9 Example 5.1 Valuing Monthly Cash Flows Problem: Suppose your bank account pays interest monthly with an effective annual rate of 6%. What amount of interest will you earn each month? If you have no money in the bank today, how much will you need to save at the end of each month to accumulate $100,000 in 10 years?

10 Example 5.1 Valuing Monthly Cash Flows Solution Plan: We can use Eq. 5.1 to convert the EAR to a monthly rate, answering the first part of the question. The second part of the question is a future value of annuity question. It is asking how big a monthly annuity we would have to deposit in order to end up with $100,000 in 10 years. However, in order to do this problem, we need to write the timeline in terms of monthly periods because our cash flows (deposits) will be monthly:

11 Example 5.1 Valuing Monthly Cash Flows Plan (cont’d): That is, we can view the savings plan as a monthly annuity with 10  12 = 120 monthly payments. We have the future value of the annuity ($100,000), the length of time (120 months), and we will have the monthly interest rate from the first part of the question. We can then use the future value of annuity formula (Eq. 4.6) to solve for the monthly deposit

12 Example 5.1 Valuing Monthly Cash Flows Execute: From Eq. 5.1, a 6% EAR is equivalent to earning (1.06) 1/12 – 1 = 0.4868% per month. The exponent in this equation is 1/12 because the period is 1/12 th of a year (a month).

13 Example 5.1 Valuing Monthly Cash Flows Execute (cont’d): To determine the amount to save each month to reach the goal of $100,000 in 120 months, we must determine the amount C of the monthly payment that will have a future value of $100,000 in 120 months, given an interest rate of 0.4868% per month. Now that we have all of the inputs in terms of months (monthly payment, monthly interest rate, and total number of months), we use the future value of annuity formula from Chapter 4 to solve this problem:

14 Example 5.1 Valuing Monthly Cash Flows Execute (cont’d): We solve for the payment C using the equivalent monthly interest rate r = 0.4868%, and n = 120 months:

15 Example 5.1 Valuing Monthly Cash Flows Execute (cont’d): We can also compute this result using a financial calculator: Given:1200.48680100,000 Solve for:-615.47 Excel Formula: =PMT(RATE,NPER,PV,FV)=PMT(.004868,120,0,100000)

16 Example 5.1 Valuing Monthly Cash Flows Evaluate: Thus, if we save $615.47 per month and we earn interest monthly at an effective annual rate of 6%, we will have $100,000 in 10 years. Notice that the timing in the annuity formula must be consistent for all of the inputs. In this case, we had a monthly deposit, so we needed to convert our interest rate to a monthly interest rate and then use total number of months (120) instead of years.

17 Example 5.1a Valuing Monthly Cash Flows Problem: Suppose your bank account pays interest monthly with an effective annual rate of 5%. What amount of interest will you earn each month? If you have no money in the bank today, how much will you need to save at the end of each month to accumulate $150,000 in 20 years?

18 Example 5.1a Valuing Monthly Cash Flows Solution: Plan: We can use Eq. 5.1 to convert the EAR to a monthly rate, answering the first part of the question. The second part of the question is a future value of annuity question. It is asking how big a monthly annuity we would have to deposit in order to end up with $150,000 in 20 years. However, in order to do this problem, we need to write the timeline in terms of monthly periods because our cash flows (deposits) will be monthly:

19 Example 5.1a Valuing Monthly Cash Flows Plan (cont’d): That is, we can view the savings plan as a monthly annuity with 20  12 = 240 monthly payments. We have the future value of the annuity ($150,000), the length of time (240 months), and we will have the monthly interest rate from the first part of the question. We can then use the future value of annuity formula (Eq. 4.6) to solve for the monthly deposit

20 Example 5.1a Valuing Monthly Cash Flows Execute: From Eq. 5.1, a 5% EAR is equivalent to earning (1.05) 1/12 – 1 = 0.4074% per month. The exponent in this equation is 1/12 because the period is 1/12 th of a year (a month).

21 Example 5.1a Valuing Monthly Cash Flows Execute (cont’d): To determine the amount to save each month to reach the goal of $150,000 in 240 months, we must determine the amount C of the monthly payment that will have a future value of $150,000 in 240 months, given an interest rate of 0.4074% per month. Now that we have all of the inputs in terms of months (monthly payment, monthly interest rate, and total number of months), we use the future value of annuity formula from Chapter 4 to solve this problem:

22 Example 5.1a Valuing Monthly Cash Flows Execute (cont’d): We solve for the payment C using the equivalent monthly interest rate r = 0.4074%, and n = 240 months:

23 Example 5.1a Valuing Monthly Cash Flows Execute (cont’d): We can also compute this result using a financial calculator: Given:2400.40740150,000 Solve for:-369.64 Excel Formula: =PMT(RATE,NPER,PV,FV)=PMT(.004074,240,0,150000)

24 Example 5.1a Valuing Monthly Cash Flows Evaluate: Thus, if we save $369.64 per month and we earn interest monthly at an effective annual rate of 5%, we will have $150,000 in 20 years. Notice that the timing in the annuity formula must be consistent for all of the inputs. In this case, we had a monthly deposit, so we needed to convert our interest rate to a monthly interest rate and then use total number of months (240) instead of years.

25 5.1 Interest Rate Quotes and Adjustments Annual Percentage Rates (APR) – Indicates the amount of interest earned in one year without the effect of compounding Simple Interest – Interest earned without the effect of compounding

26 5.1 Interest Rate Quotes and Adjustments Annual Percentage Rates (APR) – Because the APR does not reflect the true amount you will earn over one year, the APR itself cannot be used as a discount rate – Instead, the APR is a way of quoting the actual interest earned each compounding period: (Eq. 5.2)

27 5.1 Interest Rate Quotes and Adjustments Annual Percentage Rates (APR) – Converting an APR to an EAR Once the interest earned per compounding period is computed from Eq. (5.2), the equivalent interest rate for any other time interval can be computed (Eq. 5.3)

28 Table 5.1 Effective Annual Rates for a 6% APR with Different Compounding Periods

29 Example 5.2 Converting the APR to a Discount Rate Problem: Your firm is purchasing a new telephone system that will last for four years. You can purchase the system for an upfront cost of $150,000, or you can lease the system from the manufacturer for $4,000 paid at the end of each month. The lease price is offered for a 48-month lease with no early termination—you cannot end the lease early. Your firm can borrow at an interest rate of 6% APR with monthly compounding. Should you purchase the system outright or pay $4,000 per month?

30 Example 5.2 Converting the APR to a Discount Rate Solution: Plan: The cost of leasing the system is a 48-month annuity of $4,000 per month:

31 Example 5.2 Converting the APR to a Discount Rate Plan (cont’d): We can compute the present value of the lease cash flows using the annuity formula, but first we need to compute the discount rate that corresponds to a period length of one month. To do so, we convert the borrowing cost of 6% APR with monthly compounding to a monthly discount rate using Eq. 5.2. Once we have a monthly rate, we can use the present value of annuity formula Eq. 4.5 to compute the present value of the monthly payments and compare it to the cost of buying the system.

32 Example 5.2 Converting the APR to a Discount Rate Execute: As Eq. 5.2 shows, the 6% APR with monthly compounding really means 6%/12=0.5% every month. The 12 comes from the fact that there are 12 monthly compounding periods per year. Now that we have the true rate corresponding to the stated APR, we can use that discount rate in the annuity formula Eq. 4.6 to compute the present value of the monthly payments:

33 Example 5.2 Converting the APR to a Discount Rate Execute (cont’d): Using a financial calculator or Excel: Given:480.5-4,0000 Solve for:170,321.27 Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.005,48,-4000,0)

34 Example 5.2 Converting the APR to a Discount Rate Evaluate: Thus paying $4,000 per month for 48 months is equivalent to paying a present value of $170,321.27 today. This cost is $170,321.27 – $150,000 = $20,321.27 higher than the cost of purchasing the system, so it is better to pay $150,000 for the system rather than lease it. One way to interpret this result is as follows: At a 6% APR with monthly compounding, by promising to repay $4,000 per month your firm can borrow $170,321 today. With this loan it could purchase the phone system and have an additional $20,321 to use for other purposes.

35 Example 5.2a Converting the APR to a Discount Rate Problem: Your firm is purchasing a new telephone system that will last for five years. You can purchase the system for an upfront cost of $300,000, or you can lease the system from the manufacturer for $6,000 paid at the end of each month. The lease price is offered for a 60-month lease with no early termination—you cannot end the lease early. Your firm can borrow at an interest rate of 7% APR with monthly compounding. Should you purchase the system outright or pay $6,000 per month?

36 Example 5.2a Converting the APR to a Discount Rate Solution: Plan: The cost of leasing the system is a 60-month annuity of $6,000 per month:

37 Example 5.2a Converting the APR to a Discount Rate Plan (cont’d): We can compute the present value of the lease cash flows using the annuity formula, but first we need to compute the discount rate that corresponds to a period length of one month. To do so, we convert the borrowing cost of 7% APR with monthly compounding to a monthly discount rate using Eq. 5.2. Once we have a monthly rate, we can use the present value of annuity formula Eq. 4.5 to compute the present value of the monthly payments and compare it to the cost of buying the system.

38 Example 5.2a Converting the APR to a Discount Rate Execute: As Eq. 5.2 shows, the 7% APR with monthly compounding really means 7%/12=0.5833% every month. The 12 comes from the fact that there are 12 monthly compounding periods per year. Now that we have the true rate corresponding to the stated APR, we can use that discount rate in the annuity formula Eq. 4.6 to compute the present value of the monthly payments:

39 Example 5.2a Converting the APR to a Discount Rate Execute (cont’d): Using a financial calculator or Excel: Given:600.5833-6,0000 Solve for:303,014.85 Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.005833,60,-6000,0)

40 Example 5.2a Converting the APR to a Discount Rate Evaluate: Thus paying $6,000 per month for 60 months is equivalent to paying a present value of $303,014.85 today. This cost is $303,014.85 – $300,000 = $3,014.85 higher than the cost of purchasing the system, so it is better to pay $300,000 for the system rather than lease it. One way to interpret this result is as follows: At a 7% APR with monthly compounding, by promising to repay $6,000 per month for 60 months your firm can borrow $303,014.85 today. With this loan it could purchase the phone system and have an additional $3,014.85 to use for other purposes.

41 Example 5.2b Converting the APR to a Discount Rate Problem: Your firm is purchasing a new fleet of trucks that will last for six years. You can purchase the system for an upfront cost of $500,000, or you can lease the system from the manufacturer for $8,000 paid at the end of each month. The lease price is offered for a 72-month lease with no early termination—you cannot end the lease early. Your firm can borrow at an interest rate of 6% APR with monthly compounding. Should you purchase the system outright or pay $8,000 per month?

42 Example 5.2b Converting the APR to a Discount Rate Solution: Plan: The cost of leasing the system is a 72-month annuity of $8,000 per month:

43 Example 5.2b Converting the APR to a Discount Rate Plan (cont’d): We can compute the present value of the lease cash flows using the annuity formula, but first we need to compute the discount rate that corresponds to a period length of one month. To do so, we convert the borrowing cost of 6% APR with monthly compounding to a monthly discount rate using Eq. 5.2. Once we have a monthly rate, we can use the present value of annuity formula Eq. 4.5 to compute the present value of the monthly payments and compare it to the cost of buying the system.

44 Example 5.2b Converting the APR to a Discount Rate Execute: As Eq. 5.2 shows, the 6% APR with monthly compounding really means 6%/12=0.5% every month. The 12 comes from the fact that there are 12 monthly compounding periods per year. Now that we have the true rate corresponding to the stated APR, we can use that discount rate in the annuity formula Eq. 4.6 to compute the present value of the monthly payments:

45 Example 5.2b Converting the APR to a Discount Rate Execute (cont’d): Using a financial calculator or Excel: Given:720.5-8,0000 Solve for:482,716.11 Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.005,72,-8000,0)

46 Example 5.2b Converting the APR to a Discount Rate Evaluate: Thus paying $8,000 per month for 72 months is equivalent to paying a present value of $482,716.11 today. This cost is $500,000 – $482,716.11 = $17,283.89 lower than the cost of purchasing the fleet, so it is better to lease the fleet for $8,000 per month than to pay $500,000 for it.

47 5.2 Application: Discount Rates and Loans Computing Loan Payments – Consider the timeline for a $30,000 car loan with these terms: 6.75% APR for 60 months

48 5.2 Application: Discount Rates and Loans Computing Loan Payments – We can use Eq. 4.9 to find C Note: 0.0675/12 = 0.005625

49 5.2 Application: Discount Rates and Loans Computing Loan Payments – Alternatively, we can solve for the payment C using a financial calculator or a spreadsheet: Given:600.5625300000 Solve for:-590.50 Excel Formula: =PMT(RATE,NPER, PV, FV) = PMT(0.005625,60,30000,0)

50 Figure 5.1 Amortizing Loan cont.

51 Figure 5.1 Amortizing Loan (cont.)

52 Example 5.3 Computing the Outstanding Loan Balance Problem: Let’s say that you are now 3 years into a $30,000 car loan (at 6.75% APR, originally for 60 months) and you decide to sell the car. When you sell the car, you will need to pay whatever the remaining balance is on your car loan. After 36 months of payments, how much do you still owe on your car loan?

53 Example 5.3 Computing the Outstanding Loan Balance Solution: Plan: We have already determined that the monthly payments on the loan are $590.50. The remaining balance on the loan is the present value of the remaining 2 years, or 24 months, of payments. Thus, we can just use the annuity formula with the monthly rate of 0.5625%, a monthly payment of $590.50, and 24 months remaining.

54 Example 5.3 Computing the Outstanding Loan Balance Execute: Thus, after 3 years, you owe $13,222.32 on the loan

55 Example 5.3 Computing the Outstanding Loan Balance Execute: Using a financial calculator or Excel: Given:240.5625-590.500 Solve for:13,222.32 Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.005625,24, ‑ 590.50,0)

56 Example 5.3 Computing the Outstanding Loan Balance Execute: You could also compute this as the FV of the original loan amount after deducting payments: Given:360.562530,000-590.50 Solve for:13,222.41 Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.005625,36, ‑ 590.50,30000)

57 Example 5.3 Computing the Outstanding Loan Balance Evaluate: Any time that you want to end the loan, the bank will charge you a lump sum equal to the present value of what it would receive if you continued making your payments as planned. As the second approach shows, the amount you owe can also be thought of as the future value of the original amount borrowed after deducting payments made along the way.

58 Example 5.3a Computing the Outstanding Loan Balance Problem: Let’s say that you are now 2 years into a $25,000 car loan (at 5.50% APR, originally for 48 months) and you decide to sell the car. When you sell the car, you will need to pay whatever the remaining balance is on your car loan. After 24 months of payments, how much do you still owe on your car loan?

59 Example 5.3a Computing the Outstanding Loan Balance Solution: Plan: First, we must determine the monthly payment. – Note: 0.055/12 = 0.004583 Given:480.4583250000 Solve for:-581.41 Excel Formula: =PMT(RATE,NPER, PV, FV) = PMT(0.004583,48,25000,0)

60 Example 5.3a Computing the Outstanding Loan Balance Solution: Plan: The remaining balance on the loan is the present value of the remaining 2 years, or 24 months, of payments. Thus, we can just use the annuity formula with the monthly rate of 0.4583%, a monthly payment of $581.41, and 24 months remaining.

61 Example 5.3a Computing the Outstanding Loan Balance Execute: Thus, after 2 years, you owe $13,185.25 on the loan

62 Example 5.3a Computing the Outstanding Loan Balance Execute: Using a financial calculator or Excel: Given:240.4583-581.410 Solve for:13,185.25 Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.004583,24, ‑ 581.41,0)

63 Example 5.3a Computing the Outstanding Loan Balance Execute: You could also compute this as the FV of the original loan amount after deducting payments – Note: The slight difference is due to rounding Given:240.458325,000-581.41 Solve for:13,185.12 Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.004853,24, ‑ 581.41,25000)

64 Example 5.3a Computing the Outstanding Loan Balance Evaluate: Any time that you want to end the loan, the bank will charge you a lump sum equal to the present value of what it would receive if you continued making your payments as planned. As the second approach shows, the amount you owe can also be thought of as the future value of the original amount borrowed after deducting payments made along the way.

65 Example 5.3b Computing the Outstanding Loan Balance Problem: Let’s say that you are now 10 years into a $200,000 mortgage (at 4.80% APR, originally for 360 months) and you decide to sell the house. When you sell the house, you will need to pay whatever the remaining balance is on your mortgage. After 120 months of payments, how much do you still owe on your mortgage?

66 Example 5.3b Computing the Outstanding Loan Balance Solution: Plan: First, we must determine the monthly payment. – Note: 0.048/12 = 0.004 Given:3600.42000000 Solve for:-1,049.33 Excel Formula: =PMT(RATE,NPER, PV, FV) = PMT(0.004,360,200000,0)

67 Example 5.3b Computing the Outstanding Loan Balance Solution: Plan: The remaining balance on the loan is the present value of the remaining 20 years, or 240 months, of payments. Thus, we can just use the annuity formula with the monthly rate of 0.4%, a monthly payment of $1,049.33, and 240 months remaining.

68 Example 5.3b Computing the Outstanding Loan Balance Execute: Thus, after 10 years, you owe $161,694.73 on the loan

69 Example 5.3b Computing the Outstanding Loan Balance Execute: Using a financial calculator or Excel: Given:2400.4-1,049.330 Solve for:161,694.73 Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.004,240, ‑ 1049.33,0)

70 Example 5.3b Computing the Outstanding Loan Balance Execute: You could also compute this as the FV of the original loan amount after deducting payments Note: The slight difference is due to rounding Given:1200.4-200,0001049.33 Solve for:161,694.94 Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.004,120,1049.33,-200000)

71 Example 5.3b Computing the Outstanding Loan Balance Evaluate: Any time that you want to end the loan, the bank will charge you a lump sum equal to the present value of what it would receive if you continued making your payments as planned. As the second approach shows, the amount you owe can also be thought of as the future value of the original amount borrowed after deducting payments made along the way.

72 5.3 The Determinants of Interest Rates Inflation and Real Versus Nominal Rates – Nominal Interest Rates The rate at which your money will grow if invested for a certain period – Real Interest Rate The rate of growth of your purchasing power, after adjusting for inflation

73 5.3 The Determinants of Interest Rates Inflation and Real Versus Nominal Rates – The growth in purchasing power can be calculated using Equation 5.4: (Eq. 5.4)

74 5.3 The Determinants of Interest Rates Inflation and Real Versus Nominal Rates – The Real Interest Rate can be calculated using Equation 5.5: (Eq. 5.5)

75 Example 5.4 Calculating the Real Interest Rate Problem: At the start of 2008, one-year U.S. government bond rates were about 3.3%, while the inflation rate that year was 0.1%. At the start of 2011, one- year interest rates were about 0.3%, and the inflation rate that year was about 3.0%. What were the real interest rates in 2008 and in 2011?

76 Example 5.4 Calculating the Real Interest Rate Solution: Using Eq. 5.5, the real interest rate in 2008 was (3.3% - 0.1%)/(1.001) = 3.20%. In 2011, the real interest rate was (0.3% - 3.0%)/(1.03) = -2.62%.

77 Example 5.4 Calculating the Real Interest Rate Evaluate: Note that the real interest rate was negative in 2011, indicating that interest rates were insufficient to keep up with inflation: Investors in U.S. government bonds were able to buy less at the end of the year than they could have purchased at the start of the year. On the other hand, there was hardly any inflation.

78 Example 5.4a Calculating the Real Interest Rate Problem: In January 2012, one-year U.S. government bond rates were about.11%, while the inflation rate that year was 2.9%. In October 2013, one-year interest rates were about 0.12%, and the inflation rate that year was about 1.0%. What were the real interest rates in January 2012 and in October 2013?

79 Example 5.4a Calculating the Real Interest Rate Solution: Using Eq. 5.5, the real interest rate in January 2012 was (0.11% - 2.9%)/(1.029) = -2.71%. In October 2013, the real interest rate was (0.12% - 1.0%)/(1.01) = -0.87%.

80 Example 5.4a Calculating the Real Interest Rate Evaluate: Note that the real interest rate was negative in both 2012 and 2013, indicating that interest rates were insufficient to keep up with inflation: Investors in U.S. government bonds were able to buy less at the end of the year than they could have purchased at the start of the year. On the other hand, there was hardly any inflation.

81 Figure 5.2 U.S. Interest Rates and Inflation Rates, 1962 -2013

82 5.3 The Determinants of Interest Rates Investment and Interest Rate Policy – When the costs of an investment precede the benefits, an increase in the interest rate will decrease the investment’s NPV

83 5.3 The Determinants of Interest Rates Investment and Interest Rate Policy – Monetary Policy, Deflation, and the 2008 Financial Crisis During 2008, in response to the financial crisis, the U.S. Federal Reserve responded by cutting its short-term interest rate target to 0% by the end of the year Because consumer prices were falling in late 2008, the inflation rate was negative (deflation), and so even with a 0% nominal interest rate the real interest rate remained positive initially Since rates could not go lower than 0%, the United States began to consider other measures, such as increased government spending and investment, to stimulate their economies

84 5.3 The Determinants of Interest Rates The Yield Curve and Discount Rates – Term Structure The relationship between the investment term and the interest rate – Yield Curve A plot of bond yields as a function of the bonds’ maturity date – Risk-Free Interest Rate The interest rate at which money can be borrowed or lent without risk over a given period.

85 Figure 5.3 Term Structure of Risk-Free U.S. Interest Rates, November 2006, 2007, and 2008

86 5.3 The Determinants of Interest Rates The Yield Curve and Discount Rates – A risk-free cash flow of C n received in n years has the present value (Eq. 5.6) where r n is the risk-free interest rate for an n- year term

87 5.3 The Determinants of Interest Rates The Yield Curve and Discount Rates – Present Value of a Cash Flow Stream Using a Term Structure of Discount Rates (Eq. 5.7)

88 Example 5.5 Using the Term Structure to Compute Present Values Problem: Compute the present value of a risk-free five-year annuity of $1,000 per year, given the yield curve for November 2008 in Figure 5.3.

89 Example 5.5 Using the Term Structure to Compute Present Values Solution: Plan: The timeline of the cash flows of the annuity is: We can use the table next to the yield curve to identify the interest rate corresponding to each length of time: 1, 2, 3, 4 and 5 years. With the cash flows and those interest rates, we can compute the PV $1000 0 1 2 3 4 5

90 Example 5.5 Using the Term Structure to Compute Present Values Execute: From Figure 5.3, we see that the interest rates are: 0.91%, 0.98%, 1.26%, 1.69% and 2.01%, for terms of 1, 2, 3, 4 and 5 years, respectively. To compute the present value, we discount each cash flow by the corresponding interest rate:

91 Example 5.5 Using the Term Structure to Compute Present Values Evaluate: The yield curve tells us the market interest rate per year for each different maturity. In order to correctly calculate the PV of cash flows from five different maturities, we need to use the five different interest rates corresponding to those maturities. Note that we cannot use the annuity formula here because the discount rates differ for each cash flow.

92 Example 5.5a Using the Term Structure to Compute Present Values Problem: Compute the present value of a risk-free five-year annuity of $2,500 per year, given the following yield curve for July 2009. TermDate YearsJuly-09 10.54% 21.05% 31.57% 42.05% 52.51%

93 Example 5.5a Using the Term Structure to Compute Present Values Solution: Plan: The timeline of the cash flows of the annuity is: We can use the table next to the yield curve to identify the interest rate corresponding to each length of time:1, 2, 3, 4 and 5 years. With the cash flows and those interest rates, we can compute the PV $2,500 0 1 2 3 4 5

94 Example 5.5a Using the Term Structure to Compute Present Values Execute: From the yield curve, we see that the interest rates are: 0.54%, 1.05%, 1.57%, 2.05% and 2.51%, for terms of 1, 2, 3, 4 and 5 years, respectively. To compute the present value, we discount each cash flow by the corresponding interest rate:

95 Example 5.5a Using the Term Structure to Compute Present Values Evaluate: The yield curve tells us the market interest rate per year for each different maturity. In order to correctly calculate the PV of cash flows from five different maturities, we need to use the five different interest rates corresponding to those maturities. Note that we cannot use the annuity formula here because the discount rates differ for each cash flow.

96 Example 5.5b Using the Term Structure to Compute Present Values Problem: Compute the present value of a risk-free five-year annuity of $10,000 per year, given the following yield curve for December 2013. TermDate YearsDec 2013 10.58% 20.42% 30.75% 41.18% 51.62%

97 Example 5.5b Using the Term Structure to Compute Present Values Solution: Plan: The timeline of the cash flows of the annuity is: We can use the table next to the yield curve to identify the interest rate corresponding to each length of time:1, 2, 3, 4 and 5 years. With the cash flows and those interest rates, we can compute the PV $10,000 0 1 2 3 4 5

98 Example 5.5b Using the Term Structure to Compute Present Values Execute: From the yield curve, we see that the interest rates are: 0.58%, 0.42%, 0.75%, 1.18% and 1.62%, for terms of 1, 2, 3, 4 and 5 years, respectively. To compute the present value, we discount each cash flow by the corresponding interest rate:

99 Example 5.5b Using the Term Structure to Compute Present Values Evaluate: The yield curve tells us the market interest rate per year for each different maturity. In order to correctly calculate the PV of cash flows from five different maturities, we need to use the five different interest rates corresponding to those maturities. Note that we cannot use the annuity formula here because the discount rates differ for each cash flow.

100 5.3 The Determinants of Interest Rates Interest Rate Determination – Federal Funds Rate The overnight loan rate charged by banks with excess reserves at a Federal Reserve bank to banks that need additional funds to meet reserve requirements The Federal Reserve determines very short-term interest rates through its influence on the federal funds rate

101 5.3 The Determinants of Interest Rates The Yield Curve and the Economy – Interest Rate Determination If interest rates are expected to rise, long-term interest rates will tend to be higher than short-term rates to attract investors If interest rates are expected to fall, long-term rates will tend to be lower than short-term rates to attract borrowers

102 5.3 The Determinants of Interest Rates The Yield Curve and the Economy – Yield Curve Shapes Normal – Moderately upward sloping Steep – Long-term rates are much higher than short-term rates Inverted – Long-term rates lower than short-term rates

103 Figure 5.4 Yield Curve Shapes

104 Figure 5.5 Short-Term versus Long-Term U.S. Interest Rates and Recessions

105 Example 5.6 Long-Term versus Short-Term Loans Problem: You work for a bank that has just made two loans. In one, you loaned $909.09 today in return for $1,000 in one year. In the other, you loaned $909.09 today in return for $15,863.08 in 30 years. The difference between the loan amount and repayment amount is based on an interest rate of 10% per year.

106 Example 5.6 Long-Term versus Short-Term Loans Problem (cont’d): Imagine that immediately after you make the loans, news about economic growth is announced that increases inflation expectations so that the market interest rate for loans like these jumps to 11%. Loans make up a major part of a bank’s assets, so you are naturally concerned about the value of these loans. What is the effect of the interest rate change on the value to the bank of the promised repayment of these loans?

107 Example 5.6 Long-Term versus Short-Term Loans Solution: Plan: Each of these loans has only one repayment cash flow at the end of the loan. They differ only by the time to repayment: The effect on the value of the future repayment to the bank today is just the PV of the loan repayment, calculated at the new market interest rate.

108 Example 5.6 Long-Term versus Short-Term Loans Execute: For the one-year loan: For the 30-year loan:

109 Example 5.6 Long-Term versus Short-Term Loans Evaluate: The value of the one-year loan decreased by $909.09 - $900.90 = $8.19, or 0.9%, but the value of the 30-year loan decreased by $909.09 - $692.94 = $216.15, or almost 24%! The small change in market interest rates, compounded over a longer period, resulted in a much larger change in the present value of the loan repayment. You can see why investors and banks view longer-term loans as being riskier than short-term loans!

110 Example 5.6a Long-Term versus Short-Term Loans Problem: You work for a bank that has just made two loans. In one, you loaned $9,259.26 today in return for $10,000 in one year. In the other, you loaned $9,259.26 today in return for $63,411.81 in 25 years. The difference between the loan amount and repayment amount is based on an interest rate of 8% per year.

111 Example 5.6a Long-Term versus Short-Term Loans Problem (cont’d): Imagine that immediately after you make the loans, news about economic growth is announced that decreases inflation expectations so that the market interest rate for loans like these falls to 7%. Loans make up a major part of a bank’s assets, so you are naturally concerned about the value of these loans. What is the effect of the interest rate change on the value to the bank of the promised repayment of these loans?

112 Example 5.6a Long-Term versus Short-Term Loans Solution: Plan: Each of these loans has only one repayment cash flow at the end of the loan. They differ only by the time to repayment: The effect on the value of the future repayment to the bank today is just the PV of the loan repayment, calculated at the new market interest rate.

113 Example 5.6a Long-Term versus Short-Term Loans Execute: For the one-year loan : For the 25-year loan:

114 Example 5.6a Long-Term versus Short-Term Loans Evaluate: The value of the one-year loan increased by $9,345.79 - $9,259.26 = $86.53, or 0.9%, but the value of the 25-year loan increased by $11,683.55 - $9,259.26 = $2,424.29, or over 26%! The small change in market interest rates, compounded over a longer period, resulted in a much larger change in the present value of the loan repayment. You can see why investors and banks view longer-term loans as being riskier than short-term loans!

115 5.4 The Opportunity Cost of Capital Opportunity Cost of Capital aka Cost of Capital – The best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted

116 Example 5.7 The Opportunity Cost of Capital Problem: Suppose a friend offers to borrow $100 from you today and in return pay you $110 one year from today. Looking in the market for other options for investing your money, you find your best alternative option for investing the $100 that view as equally risky as lending it to your friend. That option has an expected return of 8%. What should you do?

117 Example 5.7 The Opportunity Cost of Capital Solution: Plan: Your decision depends on what the opportunity cost is of lending your money to your friend. If you lend her the $100, then you cannot invest it in the alternative with an 8% expected return. Thus, by making the loan, you are giving-up the opportunity to invest for an 8% expected return. Thus, you can make your decision by using your 8% opportunity cost of capital to value the $110 in one year.

118 Example 5.7 The Opportunity Cost of Capital Execute: The value of the $110 in one year is its present value, discounted at 8%: The $100 loan is worth $101.85 to you today, so you should make the loan.

119 Example 5.7 The Opportunity Cost of Capital Evaluate: The Valuation Principle tells us that we can determine the value of an investment by using market prices to value the benefits net of the costs. As this example shows, market prices determine what our best alternative opportunities are, so that we can decide whether an investment is worth the cost.

120 Example 5.7a The Opportunity Cost of Capital Problem: Suppose a friend offers to borrow $1,000 from you today and in return pay you $1,090 one year from today. Looking in the market for other options for investing your money, you find your best alternative option for investing the $1,000 that view as equally risky as lending it to your friend. That option has an expected return of 10%. What should you do?

121 Example 5.7a The Opportunity Cost of Capital Solution: Plan: Your decision depends on what the opportunity cost is of lending your money to your friend. If you lend her the $1,000, then you cannot invest it in the alternative with an 10% expected return. Thus, by making the loan, you are giving-up the opportunity to invest for an 10% expected return. Thus, you can make your decision by using your 10% opportunity cost of capital to value the $1,090 in one year.

122 Example 5.7a The Opportunity Cost of Capital Execute: The value of the $1,090 in one year is its present value, discounted at 10%: The $1,000 loan is worth $990.91 to you today, so you should not make the loan

123 Example 5.7a The Opportunity Cost of Capital Evaluate: The Valuation Principle tells us that we can determine the value of an investment by using market prices to value the benefits net of the costs. As this example shows, market prices determine what our best alternative opportunities are, so that we can decide whether an investment is worth the cost.

124 Chapter Quiz 1.What is the difference between an EAR and an APR quote? 2.Why does the part of your loan payment covering interest change over time? 3.What is the difference between a nominal and real interest rate? 4.What is the opportunity cost of capital?


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