PowerPoint to accompany Chapter 6 Interest Rates & Bond Valuation Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Learning Goals:  Understand the fundamentals of interest rates.  Describe the term structure of interest rates and risk premiums.  Understand the legal aspects of bond financing and bond cost.  Describe general features of bonds.  Explain and apply the bond valuation model.  Explain and apply yield to maturity (YTM) to value semi annual interest paying bonds.  . Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Interest Rate Fundamentals  Interest rates act as a regulating device that control the flow of funds between suppliers and demanders.  Interest Rate: The compensation paid by a borrower of funds to the lender, expressed as a percentage.  Required Rate Of Return: The cost of funds to a supplier/lender. Reflects the lender’s expected rate of return on an investment. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Interest Rate Fundamentals  Real Rate Of Interest: The rate where demand (for investment funds) equals supply (of savings funds) in the absence of inflation or liquidity preferences. Assumed to be stable and around 1 – 2%.  Risk Free Rate: The required return on a risk free asset (Treasury bonds). Includes the real rate of interest and the inflationary expectation. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Interest Rate Fundamentals Page 260. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Nominal Rate Of Interest  Is the actual rate of interest charged by the lender and paid by the borrower.  Includes inflation and risk components.  Is calculated by: [Equation 6.1] Where: r 1 = Nominal (actual) rate of return r * = Real rate of interest IP = Inflation premium RP 1 = Risk premium 11 RPIPrr ++= ∗ Risk Free Rate (R F ) Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Term Structure Of Interest Rates  Is the relationship between interest rates and their time to maturity.  Can be graphically depicted on a yield curve.  The yield to maturity is the annual rate of return earned by a debt security held to maturity.  At any point in time the yield curve will show the relationship between the debt’s remaining time to maturity and its yield to maturity. Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition  Three types of yield curves: 1. Downward Sloping (Inverted) – longer term borrowing is cheaper than short term. 2. Upward Sloping (Normal) – short term borrowing is cheaper than longer term. 3. Flat – longer and short term borrowing costs are similar. Term Structure Of Interest Rates – Yield Curves Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition  Used to explain the general shape of the yield curve.  Three Theories: 1. Expectation Theory: The yield curve reflects investor expectations about future interest rates and inflation. 2. Liquidity Preference Theory: Long term rates will tend to be higher than short term rates. 3. Market Segmentation Theory: The market for loans is segmented on the basis of maturity and that the supply and demand for loans within each segment determine its prevailing interest rate. Term Structure Of Interest Rates – Theories Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Risk Premiums  Vary with specific issuer and issue characteristics.