Slides For Students Of BBA And MBA

1.  Cost of Money
 Determinants of Interest Rates
@Maddy.Kaleem

2. The cost of money
 The price, or cost, of debt capital is the interest
rate.
 The price, or cost, of equity capital is the required
return. The required return investors expect is
composed of compensation in the form of
dividends and capital gains.
@Maddy.Kaleem

3. What four factors affect the cost of
money?
 Production
opportunities
 Time preferences for
consumption
 Risk
 Expected inflation
@Maddy.Kaleem

4. “Nominal” vs. “Real” rates
k = represents any nominal rate
k* = represents the “real” risk-free rate of interest.
Like a T-bill rate, if there was no inflation.
Typically ranges from 1% to 4% per year.
kRF = represents the rate of interest on Treasury
securities.
@Maddy.Kaleem

5. Determinants of interest rates
k = k* + IP + DRP + LP + MRP
k = required return on a debt security
k* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP= Maturity Risk Premium (MRP)
@Maddy.Kaleem

6. Determinants of interest rates
 Inflation Premium (IP) – A premium equal to
expected inflation that investors added to the real risk-
free rate of return.
 Real Risk-Free Rate of Interest, k*- The rate of
interest that would exist on default-free State Bank
Treasury securities if no inflation were expected.
@Maddy.Kaleem

7. Determinants of interest rates
 Default Risk Premium (DRP) - The difference
between the interest rate on a State Bank Treasury bond
and a corporate bond of equal maturity and
marketability.
 Maturity Risk Premium (MRP) - A premium which
reflects interest rate risk.
 The longer it takes, the higher the amount of premium
@Maddy.Kaleem

8. Determinants of interest rates
 Liquidity Premium (LP) - A premium added to the
equilibrium interest rate on a security if that security
cannot be converted to cash on short notice and at
close to "fair market value."
@Maddy.Kaleem

9. Premiums added to k* for different types
of debt
IP MRP DRP LP
S-T Treasury 
L-T Treasury  
S-T Corporate   
L-T Corporate    
@Maddy.Kaleem