Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 25 Chapter 5 The Cost of Money (Interest Rates)

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 25 Determinants of Market Interest Rates Rate of return (interest) = k = Risk-free rate+ Premium for risk = k RF + RP 0 Risk Return k RF Risk-Free Return = k RF Risk Premium = RP k= k RF + RP

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 25 Determinants of Market Interest Rates Quoted rate = k = k RF +RP= [k* + IP] + [DRP + LP + MRP] k* = real risk-free rate IP= inflation premium DRP= default risk premium LP= liquidity (marketability) premium MRP= maturity risk premium k* = real risk-free rate IP= inflation premium = k RF DRP= default risk premium LP= liquidity (marketability) premium MRP= maturity risk premium = RP

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 25 The Term Structure of Interest Rates Relationship between yields and bond maturities Yield (%) Term to Maturity (years) Upward sloping (normal) Downward sloping (inverted) Flat

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 25 The term structure of interest rates 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. Explanations for the shape of the yield curve

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 25 Interest rate Levels and Stock Prices 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 Effects on corporate profits

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 25 Interest rates and business decisions 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 A firm’s decision concerning what types of financing should be used for investments in assets is based on forecasts of future interest rates

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 25 Self – test problems 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 long- term rather than short-term debt –(a) TRUE –(b) FALSE Term structure of interest rates

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 25 Self – test problems And the right answer is….. (a) Term structure of interest rates

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 25 Self – test problems 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 Risk and return

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 25 Self – test problems And the right answer is….. (c) Risk and Return

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 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 one- year 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 13 of 25 Problem 2-7 Solution Given: One-year bond yield10.0% Two-year bond yield 11.5% k*3.0% MRP0.0% One-year rate In Year 2

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 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: YearOne-Year Rate 20085% 20094% 20103% –The rates given here include the risk-free rate, k RF, 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 15 of 25 Problem 2-10 – Solution YearOne-Year Rate 20085% 20094% 20103% Today = 1/1/05 3-yr yield = 6%