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FIN510 - Chapter #7.docx

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Ryerson University
ECN 204
Christopher Gore

Chapter 7 – Types and Costs of Financial Capital Implicit Versus Explicit Financial Capital Costs – Formal historical accounting procedures include explicit records of debt (interest and principal) and dividend capital costs – However, no provision is made to record the less tangible expenses of equity capital (i.e., required capital gains to complement the dividends) – cost of financial capital be explicitly incorporated in evaluations, projections, and strategy – the value of a financial claim varies inversely with the cost of that type of capital Financial Markets – Public Financial Markets: markets for the creation, sale and trade of liquid securities having standardized features o Successful, well-established corporations are the most common issuers of these public market securities, although the Internet Age has changed maturity expectations for some issuers o An initial public offering (IPO) of common stock, usually accomplished with the aid of in- vestment bankers, can provide liquidity stage financing as a successful corporate venture moves deep into its rapid-growth stage o public financial markets and financial institutions become the most common sources of financing during a successful venture’s maturity stage – Private Financial Markets: markets for the creation, sale and trade of illiquid securities having less standardized negotiated features o Early-stage ventures in the development, startup, survival, or (early) rapid-growth stages usually cannot tap into public financial markets o equity financing, early-stage ventures typically rely on private equity financing from the entrepreneur and her friends or family, from business angels, and from professional venture capitalist Determining Cost Of Debt Capital – Interest Rate: price paid to borrow funds – In debt markets, the sup- ply and demand for funds determines the interest rate new borrowers must agree to pay o riskier debt costs more – Default Risk: risk that a borrower will not pay the interest and/or principal on a loan – the quantity demanded and supplied for low-risk debt as being greater than that for high-risk debt – The distance between the two interest rates depends on the relative demand for the two types of debt and lenders’ willingness to lend at various interest rate differentials between the two types of debt – other factors—inflation expectations, marketability, and the life span of the debt instrument—play important roles in determining the supply and demand of funds and, therefore, equilibrium interest rates – Nominal Interest Rate (d ): observed or stated interest rate – Real Interest Rate (RR): interest one would face in the absence of inflation, risk, illiquidity, and any other factors determining the appropriate interest o rd= RR + IP + DRP +LP +MP  more generally, for more complicated risky debt securities at various maturities and liquidities  Borrowers must pay more than the real rate (RR) to compensate the lender (supplier of debt funds) for an inflation premium (IP), a default risk premium (DRP), a marketability or liquidity premium (LP), and a maturity premium (MP) – Risk-free Interest Rate fr ): interest rate on debt that is virtually free of default risk o During inflationary times, to offset erosion in money’s purchasing power, even risk-free securities are priced using higher interest rates o rf= RR + IP  for debt by effectively default-free borrowers (e.g. U.S. government) – Inflation: rising prices not offset by increasing quality of the goods or services being purchased – Inflation premium (IP): average expected inflation rate over the life of a risk-free loan – Default Risk Premium (DRP): additional interest rate premium required to compensate the lender for the probability that a borrower will default on a loan o The higher the quality of the loan or debt security, the lower the DRP and, therefore, the lower the nominal interest rate o “basis points,” where one percentage point is 100 basis points o early-stage venture would face a rate 500 basis points above the prevailing risk-free rate – Liquidity Premium (LP): charged when a debt instrument cannot be converted to cash quickly at its existing value – Maturity Premium (MP): premium to reflect increased uncertainty associated with long-term debt – It is important to remember that it is conventional practice to refer to the risk-free interest rate as being free from default risk, and not free from inflation risk – A venture must promise to pay substantially more than the risk-free rate to obtain debt financing – Investors expect some compensation for bearing the venture’s financial risk – Can think of d = f + DRP + LP + MP Interest Rate Relationships – RRs are relatively stable – periods of very high inflation expectations, risk-free interest rates tend to be high – risk-free interest rates shift up and down with inflation expectations – Prime Rate: interest rate charged by banks to their highest quality (lowest default risk) business customers o prime rate establishes a benchmark rate for loans to riskier customers o For example, a moderately risky customer might get a “prime plus 2 percent” loan. If the prime rate is 7 percent, this translates to a 9 percent borrowing rate (i.e., 7 percent + 2 percent) – Bond Rating: reflects the default risk of a firm’s bonds as judged by a bond rating agency – Senior Debt: debt secured by a venture’s assets – Subordinated Debt: debt with an inferior claim (relative to senior debt) to venture assets – Term Structure of Interest Rates: relationship between nominal interest rates and time to maturity when default risk is held constant – Panel A: the slope of the risk premium curve is held constant while the risk-free interest rate shifts upward and downward on the vertical axis to reflect changes in inflation expectations. As previously suggested, the risk-free rate will be high when inflation expectations are high because we add the IP to a reasonably stable RR (of about 3 percent). When inflation is expected to be 7 percent or higher annually, the risk-free rate will be at the double-digit level. In contrast, a low inflation rate of 2 percent suggests a risk-free rate of about 5 percent. – Panel B: holds the risk-free rate constant and depicts changes in the slope of the DRP with changes in expectations about the economy. When investors expect an expanding economy, they may believe that a given class of firms (such as startups) will exhibit decreased
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