Assignmentpoint
The cost of money refers to the price paid for using the money, whether borrowed or owned. In a
sentence, it is the rate of interest or dividend payment on borrowed capital. Every sum of money
used by corporations bears cost. The interest paid on debt capital and the dividends paid on
ownership capital are examples of the cost of money. The supply of and demand for capital is the
factor that affects the cost of money.
Factors that Affecting the Cost of Money
1. Production Opportunities
Production opportunities refer to the profitable opportunities for investment in productive assets.
Increase in production opportunities in an economy increases the cost of money. Higher the
production opportunities more will be the demand for money which leads to a higher cost of
money.
2. Time Preference For Consumption
Time preference for consumption refers to the preference of consumers for current consumption
as opposed to future consumption. The cost of money also depends on whether the consumers
prefer to consume in the current period or in the future period. If consumers prefer to consume in
the current period, they spend a larger portion of their earnings in current consumption. It leads
to lower saving. Lower saving reduces the supply of money causing the cost of money increase.
Therefore, as much as the consumers give high preference to current consumption, the cost of
money will increase and vice versa.
3. Risk
Risk refers to the chance of loss. In the context of financial markets, risk means the chance that
investment would not produce promised return. The degree of risk perceived by investors and
the cost of money has a positive relationship. If an investor perceives a high degree of risk
from a given investment alternative, he or she will demand a higher rate of return, and hence the
cost of money will increase.
4. Inflation
Inflation refers to the tendency of prices to increase over periods. The expected future rate of
inflation also affects the cost of money, because, it affects the purchasing power of investors.
Increasing in a rate of inflation results in a decline in purchasing power of investors. The
investors will demand a higher rate of return to commensurate against a decline in purchasing
power because of inflation.
Bartebly
The four fundamental factors that affect the supply of and demand for investment capital, and
hence interest rates, are productive opportunities, time preferences for consumption, risk, and
inflation. Explain how each of these factors affects the cost of money. In your dicussion, explain
why a hospital 's bond rating is important and describe the different levels. (You can use any
bond rating agency for analysis).
Productive opportunities is the supply and demand of capital are based on the businesses
profitability. The higher the profits the higher the interest rate. Conversely , the low the
profitability the lower the interest rate. The ability to borrow money is enhance if the lender
perceives the business as profitable and the risk is lower.
Time preferences are based on their time for consumption and solely by personal preferences.
This is dependent on the needs of the investor. The basis of this if the investor wishes to save his
money for the future, that investor may accept a low return for future consumption. An investor
who has the need for high consumption (needs money in the short term), will lend the money
only if the interest rate is high. The needs of the investor will play into the ability for a business
to borrow money. If an all investors need long term, future returns, then interest rates would
lower, if the investor needs money in the short term the interest paid to attract the investor
and their capital will need to be higher.
Scirbd
Course hero
The four most fundamental factors affecting the cost of money are (1) production opportunities, (
2) time preferences for consumption, (3) risk, and (4) inflation.
Production opportunities are the investment opportunities in productive (cash-generating) assets.
Time preferences for consumption are the preferences of consumers for current consumption as
opposed to saving for future consumption.
Risk, in a financial market context, is the chance that an investment will provide a low or negativ
e return.
Inflation is the amount by which prices increase over time.
Factors That Affect the Cost of Money—factors that determine interest rates are those that affect
the supply of, and the demand for, funds.
o Production Opportunities—greater production opportunities should create opportunities for
greater returns on investments, thus the ability to pay higher interest rates (greater demand for
funds).
o Time Preference for Consumption—the greater the need for current consumption, the less
willing individuals are to save, thus lend funds, which means interest rates will be higher (less
supply of funds).
o Risk—investors demand higher returns for riskier investments; if the expected returns were
the same for all investments, regardless of risk, investors generally would not invest in higher
risk investments because they would perceive greater uncertainty about whether they would be
repaid than for lower risk investments.
o Inflation—investors save to increase their ability to purchase in the future; thus, if the prices of
goods and services are expected to increase, investors must demand a return greater than the
expected price increases to be able to purchase greater amounts of the same products in the
future.
Mr. Shahin has 1500 TK and he wants to buy 40kg rice to feed his family. So, Mr. Shahin has
decided to do current consumption. Mr. Rafiq has 2000TK and he wants to save it for future
consumption so that he has decided to deposit it in a bank. So, Mr. Rafiq is preferring future
consumption. Now, the bank has to give lower cost of money to Mr. Rafiq. On the other hand, to
encourage Mr. Shahin, the bank has to offer him higher rate of interest so that he changes his
decision of current consumption and deposit the money in the bank.
Maturity risk premium will increase with respect to the length of maturity. Maturity risk
premium (MRP) is a premium that reflects the interest rate risk. The prices of long-term bonds
decrease whenever the interest rate rise. Interest rate can rise occasionally so that all long-term
bonds even treasury bonds have an element of risk called interest rate risk. The bonds of an
organization have more interest rate risk with respect to the length of maturity or duration. So,
“the longer the maturity period of the bonds, the higher the maturity risk premium.”
