Questions 49
Four fundamental factors affect the cost of money: (1) production opportunities,
(2) time preferences for consumption,(3) risk,and (4) inflation.
The risk-free rate of interest, rRF,is defined as the real risk-free rate, r*, plus an
inflation premium, IP, hence rRFr* IP.
The nominal(or quoted) interest rateon a debt security, r,is composed of the
real risk-free rate, r*, plus premiums that reflect inflation (IP), default risk (DRP),
liquidity (LP), and maturity risk (MRP):
r r* IP DRP LP MRP.
If the real risk-free rate of interest and the various premiums were constant
over time,interest rates would be stable. However, both the real rate and the
premiums—especially the premium for expected inflation—do change over time,
causing market interest rates to change.Also, Federal Reserve intervention to
increase or decrease the money supply, as well as international currency flows, lead
to fluctuations in interest rates.
The relationship between the yields on securities and the securities’ maturities is
known as the term structure of interest rates,and the yield curveis a graph of
this relationship.
The shape of the yield curve depends on two key factors: (1) expectations about
future inflationand (2) perceptions about the relative riskiness of securities
with different maturities.
The yield curve is normally upward sloping—this is called a normal yield curve.
However, the curve can slope downward (an inverted yield curve) if the inflation
rate is expected to decline. The yield curve can be humped,which means that in-
terest rates on medium-term maturities are higher than rates on both short- and
long-term maturities.
Questions
Define each of the following terms:
a.Sole proprietorship; partnership; corporation
b.Limited partnership; limited liability partnership; professional corporation
c.Stockholder wealth maximization
d.Money market; capital market; primary market; secondary market
e.Private markets; public markets; derivatives
f. Investment banker; financial service corporation; financial intermediary
g.Mutual fund; money market fund
h.Physical location exchanges; computer/telephone network
i.Open outcry auction; dealer market; electronic communications network (ECN)
j.Production opportunities; time preferences for consumption
k.Real risk-free rate of interest, r*; nominal risk-free rate of interest, rRF
l.Inflation premium (IP); default risk premium (DRP); liquidity; liquidity premium (LP)
m. Interest rate risk; maturity risk premium (MRP); reinvestment rate risk
n.Term structure of interest rates; yield curve
o.“Normal” yield curve; inverted (“abnormal”) yield curve
p.Expectations theory
q.Foreign trade deficit
What are the three principal forms of business organization? What are the advantages and dis-
advantages of each?
What are the three primary determinants of a firm’s cash flow?
1–4 What are financial intermediaries, and what economic functions do they perform?
1–3
1–2
1–1
An Overview of Corporate Finance and the Financial Environment 47
