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In our last module we used our net present value formula to illustrate how
investment decisions are driven in large part by the level of interest rates.
In a nutshell, we found that the higher the interest rate the more expensive
the cost of money is and the less desirable any given investment will be.
Now here's a bit of a new twist for this module.
So far we have assumed that there is only one interest rate that will be
available to all companies.
That turns out to not be the case at all.
In fact, businesses large and
small actually face a wide range of interest rates in the marketplace.
And this range of rates is based on a variety of important factors.
[SOUND] These factors include, the degree of loan risk faced by the lender,
the size of the loan, the length of maturity of the loan.
And the taxability, or lack thereof,
of the interest income the lender derives from the loan.
Now looking at each of these factors,
how do you think each will affect the interest rate?
For example, will the interest rate rise or fall with the length or
size of any given loan?
Take a minute to jot down your thoughts before I provide my own explanation as
we pause the presentation.
[MUSIC]
[SOUND] Okay, let's start with risk.
Suppose you have the choice of lending $100 to either
General Motors or the Fly By Knight Corporation.
Which company is most likely to pay you back with interest?
Well hopefully you said the far more well known and well established General Motors.
[SOUND] And the point is that if you were to lend your money instead to
Fly By Knight, you would probably want to charge them a higher interest rate to
compensate for the risk of lending to a smaller and
far less known company that might not repay the loan.
And higher rate for risk is known at the risk premium and
the specific type of risk is known as default risk.
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Now what about the length of the loan?
Here the general rule is that the longer the term of the loan,
the higher the interest rate.
This is to compensate the long term lender for the inconvenience and
possible financial sacrifice of foregoing alternative uses use or
her money for a greater length of time.
In addition, the longer the loan period the greater the possibility
that the inflation rate may rise because of broader macroeconomic conditions.
For example a booming economy typically drives up the inflation rate.
[SOUND] In such a case if the borrower has locked into a lower interest rate,
that's great for the borrower.
But for the lender it means getting paid off in dollars or euros or
yen that have lost some of their value due to the erosion of inflation.
Yes, we will talk a whole lot more about that in our
companion course, Macroeconomics for Business.
[MUSIC]
As for loan size, given two loans that are both equal in length and risk,
the interest rate usually will be somewhat higher on the smaller of the two loans.
Why is this so?
Simply because the administrative costs of a large and
a small loan are about the same.
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As for the taxability, this will depend on the country you're in and its tax policy.
For example in the United States, interest income from certain state and
municipal bonds is exempt from federal income taxation.
Such tax exemptions, in turn, lower the interest rates on tax-exempt bonds.
Because the demand for these bonds from investors seeking
lower taxes drive up the cost of the bonds and
therefore drive down bond yields and interest rates.
And again, these are the kinds of dynamic relationships we will
cover in much more detail in our companion macroeconomics course.
But for now, let's let an example suffice.
[SOUND] Suppose then, that you earn over $100,000 a year.
And that this puts you in a tax bracket of say, 28%.
What this means is that for every additional $1 over $100,000
that you earn you must pay the government $0.28.
Now here's your choice, you can invest in a $100,000 municipal bond,
which pays 6% in tax free interest.
Or you can invest in a taxable corporate bond paying 8%.
Which bond would you choose?
Take a minute to think this through, and jot down your answer before you move on.
[MUSIC]
Well in our example,
the tax-free bond will provide you $6,000 of interest income,
which is obviously less than the $8,000 you would receive from the corporate bond.
But you won't have to pay the government any taxes on the income.
In contrast, if you opt for the corporate bond,
you're going to owe the government $2,240 in taxes.
Which would calculate by multiplying the $8,000 in pre-tax
interest income times your marginal tax rate of 28%.
Clearly then, you will prefer the lower interest rate with the tax-free bond.
This is because you wind up after taxes,
with $240 more than you would have with the corporate bond.
And that's a pretty cool example to end this module with.
Take a well earned rest, and when you are ready,
let's move on to our final module in this lesson.
[MUSIC]
Dr. Peter NavarroProfessor
