What do we call the price, or cost, of debt capital? The interest rate What do we call the price, or cost, of equity capita Required- Dividend Capital return yI ield gain Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 6 Copyright © 2002 by Harcourt, Inc. All rights reserved. ◼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 Capital return yield gain = +
5-7 What four factors affect the cost of money ? Production opportunities Time preferences for consumption I Risk ■ Expected inflation Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 7 Copyright © 2002 by Harcourt, Inc. All rights reserved. What four factors affect the cost of money? ◼Production opportunities ◼Time preferences for consumption ◼Risk ◼Expected inflation
5-8 Real versus nominal rates k* Real risk-free rate T-bond rate if no inflation 1%to4% k Any nominal rate kre Rate on Treasury securities Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 8 Copyright © 2002 by Harcourt, Inc. All rights reserved. Real versus Nominal Rates k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. k kRF
kEk+IP+ DRP LP MRP Here k Required rate of return on a debt security. k*= Real risk-free rate IP Inflation premium DRP E Default risk premium LP E Liquidity premium MRP= Maturity risk premium Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 9 Copyright © 2002 by Harcourt, Inc. 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
5-10 Premiums added to k for different ypes of Debt ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: STIP DRP LP LT corporate: IP, DRP, MRP, LP Copy right C 2002 by Harcourt, Inc. All rights reserved
5 - 10 Copyright © 2002 by Harcourt, Inc. All rights reserved. Premiums Added to k* for Different Types of Debt ◼ST Treasury: only IP for ST inflation ◼LT Treasury: IP for LT inflation, MRP ◼ST corporate: ST IP, DRP, LP ◼LT corporate: IP, DRP, MRP, LP