INTEREST RATES
Introduction
Companies raise CAPITAL in two main forms: 1) debt and 2) equity.
In a free economy, capital is allocated through a market system
Funds are transferred and Prices are established
Cost of Debt - Interest rate (price that lenders receive and borrowers pay for debt capital)
Cost of Equity - Dividends + Capital Gains (expected to be received by equity investors)
The Cost of Money
Example: Visualize an isolated island community where people live on fish. They have a stock of fishing gear
that permits them to survive reasonably well, but they would like to have more fish. Now suppose one of the
inhabitants, Mr. Crusoe, had a bright idea for a new type fishnet 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 efficiently. 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 1 fish a day for a year, he would return
2 fish a day the next year. If someone accepted the offer, the fish that Ms. Robinson and the others gave to Mr.
Crusoe would constitute savings, these savings would be invested in the fishnet, and the extra fish the net
produced would constitute a return on the investment.
4 Fundamental Factors affecting the Cost of Money:
1. Production opportunities
investment opportunities in productive (cash-generating) assets
➢ The more productive Mr. Crusoe thinks the new fishnet would be, the more he could afford to offer
potential investors for their savings
➢ Possible offers:
1 fish : 2 fishes 100% rate of return
1 fish : 1.5 fish 50% rate of return
2. Time preferences for consumption
preferences of consumers for current consumption as opposed to saving for future consumption
➢ How attractive the offer appeared to a potential saver would depend in large part on the saver’s time
preference for consumption.
➢ Ms. Robinson: thinking of retirement, thus, willing to trade fish today for fish in the future on a 1:1
basis
➢ Mr. Friday: family man (wife and several children), thus, needs his current fish; so, might be unwilling to
lend a fish today for anything less than 3 fish next year
➢ Mr. Friday - high time preference for current consumption
Ms. Robinsion - low time preference for current consumption
➢ Note: if the entire population was living right at the subsistence level
o time preferences for current consumption high
o aggregate savings low
o interest rates high
capital formation would be difficult
3. Risk
in a financial market context, the chance that an investment will provide a low or negative return
➢ The risk inherent in the fishnet project (Mr. Crusoe’s ability to repay the loan) also affects the return
that investors require:
o The higher the perceived risk, the higher the required rate of return
4. Inflation
the amount by which prices increase over time
➢ In a more complex society,
o there are many businesses like Mr. Crusoe’s (many goods other than fish)
o there are many savers like Mr. Friday and Ms. Robinson
people use money as a medium of exchange (rather than barter of fish)
➢ When money is used, its value in the future, which is affected by inflation, comes into play.
o The higher the expected rate of inflation, the larger the required dollar return.
SUMMARY
The interest rate paid to savers depends on the following factors:
1) Rate of return that producers expect to earn on invested capital
2) Saver’s time preferences for current versus future consumption
3) Riskiness of the loan
4) Expected future rate of inflation
Producers’ expected returns on their business investments set an upper limit to how
much they can pay for savings.
Consumers’ time preferences for consumption establish how much consumption they
are willing to defer and, hence, how much they will save at different interest rates.
Higher risk and higher inflation also lead to higher interest rates.
