Companies raise capital in two main forms: debt and equity. In a free economy, capi-
tal, like other items, is allocated through a market system, where funds are trans-
ferred and prices are established. The interest rate is the price that lenders receive
and borrowers pay for debt capital. Similarly, equity investors expect to receive divi-
dends and capital gains, the sum of which represents the cost of equity. We will take
up the cost of equity in a later chapter, but our focus in this chapter is on the cost of
debt. We begin by examining the factors that a! ect the supply of and demand for
capital, which, in turn, a! ects the cost of money. We will see that there is no single
interest rate—interest rates on di! erent types of debt vary depending on the bor-
rower’s risk, the use of the funds borrowed, the type of collateral used to back the
loan, and the length of time the money is needed. In this chapter, we concentrate
mainly on how these various factors a! ect the cost of debt for individuals; but in
later chapters, we delve into cost of debt for a business and its role in investment
decisions. As you will see in Chapters 7 and 9, the cost of debt is a key determinant
of bond and stock prices; it is also an important component of the cost of corporate
capital, which we take up in Chapter 10.
When you " nish this chapter, you should be able to:
- List the various factors that in# uence the cost of money.
- Discuss how market interest rates are a! ected by borrowers’ need for capital,
expected in# ation, di! erent securities’ risks, and securities’ liquidity.- Explain what the yield curve is, what determines its shape, and how you can use
the yield curve to help forecast future interest rates.led to a decline in the rate the government had to pay
when it borrowed. At the same time, investors demanded
much higher rates from corporate borrowers—particularly
those thought to be especially risky.
The subprime mortgage crisis demonstrates how major
shocks to the economy can have profound effects on inter-
est rates in a wide number of markets, all of which are
interconnected. Looking ahead, it will be interesting to see
if interest rates can continue to remain low and if not,
whether the economy can continue to perform as well as it
has in the past.P U T T I N G T H I N G S I N P E R S P E C T I V E
Chapter 6 Interest Rates 1636-1 THE COST OF MONEY
The four most fundamental factors affecting the cost of money are (1) production
opportunities, (2) time preferences for consumption, (3) risk, and (4) in! ation.
To see how these factors operate, visualize an isolated island community where
people live on! sh. They have a stock of! shing gear that permits them to survive
reasonably well, but they would like to have more! sh. Now suppose one of the
island’s inhabitants, Mr. Crusoe, had a bright idea for a new type of! shnet that
would enable him to double his daily catch. However, it would take him a year to
perfect the design, build the net, and learn to use it ef! ciently. Mr. Crusoe would
probably starve before he could put his new net into operation. Therefore, he
might suggest to Ms. Robinson, Mr. Friday, and several others that if they would
give him one! sh each day for a year, he would return two! sh a day the next
year. If someone accepted the offer, the! sh that Ms. Robinson and the others gave
Production
Opportunities
The investment
opportunities in productive
(cash-generating) assets.
Time Preferences for
Consumption
The preferences of
consumers for current
consumption as opposed
to saving for future
consumption.Production
Opportunities
The investment
opportunities in productive
(cash-generating) assets.
Time Preferences for
Consumption
The preferences of
consumers for current
consumption as opposed
to saving for future
consumption.Risk
In a financial market
context, the chance that
an investment will provide
a low or negative return.
Inflation
The amount by which
prices increase over time.Risk
In a financial market
context, the chance that
an investment will provide
a low or negative return.
Inflation
The amount by which
prices increase over time.