Interest Rates and Cost of Capital
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Questions:
1. Compare long-term instruments and short-term risks, in terms of the various types of risk to which investors are exposed. Explain your answers.
2. What methods can be used by the FED to influence interest rates? Are these methods effective? Use examples where appropriate.
3. If a company is going to finance a project entirely with retained earnings, what would be the cost of that capital? Why?
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Solution Summary
This solution looks at the short-term risks associated with varying financial instruments, particularly bonds and common stock. It then looks at various tools that the Fed has in its disposal to influence interest rates via its federal funds rate and discount rate. Finally, this problem also addresses the realities of fully financing a project with only retained earnings, and looks at the three ways to calculate the cost of those earnings: Capital Asset Pricing Model (CAPM), bond yield and risk premium, and discounted cash flow (DCF).
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Interest Rates and the Cost of Capital
1. Compare long-term instruments and short-term risks, in terms of the various types of risk to which investors are exposed. Explain your answers.
Bonds: This is definitely a more secure investment option, as a bond is a debt instrument. This implies that it offers a fixed claim to the potential investor, with returns that may be small and predictable, but fixed. Basically, those who hold bonds must be paid, before the stockholders of a company- especially important if the company were to go into debt, for instance. This is because a bondholder is practically lending money to the government or to companies, expecting that he/she will receive a fixed payment of interest (provided by the bond's coupon rate) biannually for the most part. The bond has a maturity date, which can lie between 3 months and 30 years even, and this bond's principal original amount is set to be paid back in full by the maturity date.
Common Stock: This is not as secure as a bond, as common stocks fall under the category of an equity instrument, meaning an investor would only have a residual claim to be paid their stock value in full if the company invested were to go bankrupt. However, though the risk in being paid back is higher, so is the potential return on the stocks. In having common stock of a public corporation, the stockholder has a partial ownership of the company, ...
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