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The interest rate is the price that lenders receive and borrowers pay for debt capital. Similarly, equity investors expect to receive dividends and capital gains, the sum of which represents the cost of equity.

195 Although the Federal Reserve has a tremendous influence on interest rates, other factors have helped keep interest rates low. Most notably, inflation remains low and foreign investors have maintained a strong willingness to purchase U.S. securities. Looking ahead, there is a concern that some of these forces may start working in reverse. Moreover, if inflation does pick up, this would also likely lead to a drop in the value of the U.S. dollar. At the same time, federal budget deficits also put upward pressure on interest rates. To the extent that deficits and inflation fears combine with a weakening dollar, foreign investors may sell U.S. bonds, which would put even more upward pressure on rates. Because corporations and individuals are greatly affected by interest rates, this chapter takes a closer look at the major factors that determine those rates. As we will see, there is no single interest rate—various factors determine the rate that each borrower pays—and in some cases, rates on different types of debt move in different directions. With these issues in mind, we will also consider the various factors influencing the spreads between long- and short-term interest rates and between Treasury and corporate bonds. Sources: John Hilsenrath and Victoria McGrane, “Yellen Stakes Out a Flexible Policy Path,” The Wall Street Journal (www.wsj.com), April 16, 2014; Jeff Cox, “Fed to Keep Easing, Sets Target for Rates,” CNBC (www.cnbc.com), December 12, 2012; Eric Morath, “Brisk Jobs Growth Puts Fed on Notice,” The Wall Street Journal Weekend, March 7–8, 2015, pp. A1–A2; and Patti Domm, “Fed Surprises with Three Rate Hikes Next Year—And It Could Need to Do More,” CNBC (www.cnbc.com), December 14, 2016. PUTTING THINGS IN PERSPECTIVE Companies raise capital in two main forms: debt and equity. In a free economy, capital, like other items, is allocated through a market system, where funds are transferred and prices are established. The interest rate is the price that lenders receive and borrowers pay for debt capital. Similarly, equity investors expect to receive dividends and capital gains, the sum of which represents the cost of equity. We take up the cost of equity in a later chapter, but our focus in this chapter is on the cost of debt. We begin by examining the factors that affect the supply of and demand for capital, which in turn affects the cost of money. We will see that there is no single interest rate—interest rates on different types of debt vary depending on the borrower’s risk, the use of the funds borrowed, the type of collateral used to back the loan, and the length of time the money is needed. In this chapter, we concentrate mainly on how these various factors affect the cost of debt for individuals, but in later chapters, we delve into the cost of debt for a business and its role in investment decisions. As you will see in Chapters 7 and 9, the cost of debt is a key determinant of bond and stock prices; it is also an important component of the cost of corporate capital, which we cover in Chapter 10. Copyright 2019 Cengage Learning.

 

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