The Cost of Money
Factors that influence the cost of money
There are four major factors that influence the cost of money. The cost of money is influenced by the ability to turn capital into benefits. This is referred to as production opportunities. Financers may prefer to use their funds for current consumption (at a higher interest rate) or save them for increased future consumption. This is referred to as ‘time preference consumption’. Thirdly, if providers perceive investments as risky they need higher returns as this will motivate them to spend more (Brigham and Ehrhardt 2008).
Consideration of inflation in making budget decisions
Allocation of capital within companies is affected by many factors, key among them being the prevailing rates of interest. Increase in inflation means an increase in “capital markets constrains” which in effect makes the allocation and relocation of capital inefficient (Hendershott and Hu 1983).
Rate of Return = Risk Free Rate + RP.
Risk free rate only exist in theory since practically rate of returns cannot be free of risk. In theory, risk free rate in taken to be the least returns on investment desirable for an investor and has no risk unless the rate of risk for that investment is lower than the returns. Risk premiums are seen as payments paid for hazardous/risky investment. As the risk free rates increase, the rate premiums also increase (Damodaran 2008).
Risk Premium (RP) is the yield of an investment expected on top of the risk-free rate. The Default Risk Premium (DRP) is the return that represents the compensation for the possibility of default. On the other hand, Liquidity Premium (LP) is that premium that an investor will expect when any given security can not be readily converted into liquid-cash, and converted at the reasonable market value.
Maturity risk Premium (MRP) is the risk that is associated with the uncertainty of interest rate.
Bond Yields and Prices
What are “yield curves” and why are they important to financial markets?
The relationship between the cost of borrowing and the corresponding currency can be represented graphically to generate a curve. Yield curves are commonly used in the financial markets and are the main indicators about the values (and attractiveness) of specific currencies. In the bond markets yield curves have an effect on the prices of bonds. As a bond approaches maturity, volatility decreases (Cwik 2005).
Key theories of the “term structure of interest rates ’
The expectations theory proposes that for maximum returns one can buy a one year bond and reinvest the return after its maturity into one year bonds. This helps to moderate interest rates (r) thus: (r1+ r2)/2 = moderated interest rates. Credit markets are fragmented into separate and distinct segments.
The circumstance for the Separation (S) and distinction (D) establishes the rates of interest. This is the market segmentation theory. Thirdly, liquidity premium theory is a modification of the expectation theory in that it basically assumes that investors demand for long term bonds because of the investors’ nature to be risk-averse (Russell 1992).
Why bond prices (valuations) are inversely related to interest rates
Bond prices and interest rates are inversely related because a rise in interest rates will push the price of the bond downwards. This is because interest rates does not increase with the maturity of the bond (new bonds have a relatively higher interest rates compared to the older bonds) (Agrawal 2007).
Capital Budgeting
Capital budgeting is based on a number of principles such as:
- Cash flow, as opposed to income, is the basis under which budgeting for capital is done
- The movement of expenses and revenues within a firm are determined by opportunity cost.
- Capital expenditure should be timely so that returns can be realised faster
- Revenues should only be considered after the effects of the prevailing interest rates are accounted for
- The cost of financing a business should be accounted for while calculating the rates of return for that business (Shapiro 2005).
Incorporating “inflation risk” into capital budgeting analysis
The probability that the value assets may reduce as inflation rises is referred to as inflation risk. The higher the inflation rates, the lower the firms’ ability and willingness to restrict net budgetary allocation. For instance, current assets (valued at $ 10m) and liabilities ($ 5m) are affected equally by inflation rates. Thus, a 10% inflation rates realizes a 10 % increase in current assets (by $1m) and liabilities ($0.5m) (Mills 1996).
Connection between the “weighted average cost of capital” and the time value of money
Most companies intend to make future cash flow equal to current cash flows and as such, they have to choose a favorable discounting rate. These choices are based on the concept of time values for money and they are determined by industry related risks. To evaluate the company cash flow, companies choose specific discounting rates (Tsui 2005).
Arbitrage and Hedging
The purchase of an asset or portfolio in order to insure against wealth fluctuations from other sources, always it comes with a price such as fees and commissions and it must be weighed against the objective of hedging. The reason for hedging is protection from unexpected changes so as to maximize the shareholders wealth.
Regulation principles ensure that there is a fair trading environment and that no individual company manipulates markets to the disadvantage of others. These regulations are informed by a number of theories such as the single regulator theory within which a single regulator acts as the gatherer and distributor of information and as such, remains the absolute regulation coordinator to ensure harmony and avoid conflict of interest (Welch & Davies 2009).
In the efficient markets arbitrageurs, investors and speculators play similar roles. Just like speculators and investors, the role of arbitrageurs is to ensure that there is standard financing in the markets. They attain this by trading in alternative securities to ensure that prices of the alternative securities are retained at stable.
Regardless of the similarities, there also exists contrast between, while arbitrageurs make purely rational decisions on investments, speculators and other investors utilize sentiments and other forms of market biases to make their investments (Shleifer & Summers 1990).
Difference between hedging and speculation
Hedging is necessary when there is a need to optimize losses and gains. Speculation is an attempt to gain from betting on directing the assets which are to be moved. Hedgers try to exclude all possible hazards by taking the contrary position in the market relatively the things they are hedging (Cootner 1967). It is beneficial in hedging to make one thing to cancel another. Speculators try to guess the possible heading of the market.
Reference List
Agrawal, D., 2007. Bonds and interest rates. Web.
Brigham, E., & Ehrhardt, M., 2008. Financial management: Theory & Practice (with Thomson ONE – Business School Edition 1-Year Printed Access Card), 12th edn. Mason, OH: South-Western College Pub.
Cootner, P., 1967. Speculation and hedging. Web.
Cwik , P., 2005. The inverted yield curve and the economic downturn. New Perspectives on Political Economy, 1 (1), pp. 1-37.
Damodaran, A., 2008. What is the risk free rate? A search for the basic building block. Stern School of Business, New York University. Web.
Hendershott, P. & Hu, S., 1983. The allocation of capital between residential and nonresidential uses: Taxes, inflation and capital market constraints. The Journal of Finance. Web.
Mills, G., 1996. The impact of inflation on capital budgeting and working capital. Journal of Financial and Strategic Decisions, 9 (1), pp. 79-87.
Russell, S., 1992. Understanding the term structure of interest rates: The expectations theory. Web.
Shapiro, J., 2005. Capital ‑Budgeting Principles and Techniques. Web.
Shleifer, A., & Summers. L., 1990. The noise trader approach to finance. Journal of Economic Perspectives. Web.
Tsui, M., 2005. Valuing innovative technology R&D as a real option: Application to fuel cell vehicles. Web.
Welch, I., & Davies, J., 2009. The Future of Financial Regulation. Web.