TOPIC: COST OF FINANCIAL CAPITAL BASICS

I. DETERMINANTS OF MARKET INTEREST RATES (k)

[Also referred to as Quoted or Nominal interest rates]

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A. DEFAULT RISK-FREE RATE (RF)

k = RF, or k = RR + IP

(where RF is the sum of the Real Rate (RR) and Inflation Premium (IP)

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[For example, the interest rate on a One-Year Treasury Bill (viewed as being “free” of default risk and thus is risk-free) would be determined by a real rate plus the expected inflation premium.]

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B. MATURITY RISK PREMIUM (MRP)

k = RF + MRP

[Uncertainty about the future and price volatility increase with maturity and lenders charge a premium for this risk.]

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C. DEFAULT RISK PREMIUM (DRP)

k = RF + MRP + DRP, or k = RF + DRP

(when the MRP impact is removed by holding maturity constant.)

[Reflects the probability that the issuer of the security will default by not paying promised interest and principal.]

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D. LIQUIDITY PREMIUM (LP)

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II. BOND RATINGSInvestment Grade Ratings: AAA to BBBHigh Yield (Junk Bond) Ratings: < BBBBond Ratings Indicate Default RiskDeterminants of Bond Ratings a. Debt Ratios: (e.g., total debt / total assets, or total debt / total capital) b. Interest Coverage: (EBIT / Interest) c. Return on Capital: (EBIT / total

capital)d. Other Ratios

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III. RATES OF RETURN ON COMMON STOCKS VERSUS BONDS

A. HISTORICAL RELATIONSHIPS

[Ibbotson, Stocks, Bonds, Bills, and Inflation (Chicago: Morningstar, Inc., annual Yearbook]

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Factors:

1. Returns are Higher, on Average Over Time, for Common Stocks Relative to Bonds

2. Risk, as Reflected in Variability or Volatility of Returns, is Greater for Common Stocks Relative to Bonds

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B. FACTORS THAT EXPLAIN P/E MULTIPLES Margins: (net income / net sales)Returns: (net income / common

equity or total capital)Financial Leverage: (total debt /

total assets or total capital) [note: this is a negative relationship]

Dividend Payout: (cash dividends / net income)

EPS Growth: (EPS proj. growth rates)

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C. P/E RATIOS VS. EPS GROWTH RATESPEG Ratio: P/E ratio / EPS growth rateFor example, if P/E is 15 times where

the stock price is $30 and the EPS is $2.00, investors are willing to pay 15 times the current earnings.

Why? Investors believe EPS will grow rapidly in the future.

Analysts generally believe that a PEG ratio of 1.0 to 2.0 is sustainable. For a 15 P/E, EPS is expected to grow at 7.5% to 15%.

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D. RELATIONSHIPS FOR A SPECIFIC FIRM

1. Common Stock (or Common Equity) is More Costly than the Firm’s Bonds

2. Reasons for a Cost Differential: a. Debt holders have a prior claim on

income and assets b. Equity returns are riskier since they come from a combination of dividend yield and price appreciation

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