Appreciating investment valuation models (VII)
The previous publication laid emphasis on valuation models and their influential role in meaningful and productive investment decisions of governments, agencies of governments, management teams of corporate organisations and investors.
Advertisement
Discussions in the last feature ended on equity valuation and free cash flow to equity valuation models and their impact on investment decisions and valuations.
Determinants of market interest rates
The financial market is often inundated with different securities; that is, it does not have one security. All things being equal, the existence of different debt securities means the availability of different interest rates in the securities (financial) market. The fundamental determinants of interest rates in the securities market are the forces of demand and supply; interactions between sellers (securities issuers) and buyers (securities buyers) in the securities market influence, to a very great extent, the interest rate quoted. Stability in the interest rate is witnessed when supply of securities equals demand in the financial market.
However, the activities of a firm would enhance its reputation and increase its creditworthiness. Under this circumstance, demand for the firm’s debts by investors may exceed the quantity the firm may be willing to supply; this would lead to an excess demand over supply. All else held constant, an increase in demand over supply would result in a downward review of the security’s interest rates.
Conversely, poor operational performance by the firm could impact negatively on its ratings and patronage of its securities by investors in the debt market. Loss of interest in the firm’s securities means investors may not be willing to pay a higher price for them; investors may ascribe a higher risk perception index to the company’s securities and as a result, may not be attracted to lower market interest rates. To encourage investors to purchase its debt, the company would have to offer a higher market interest rate for its securities. Thus, to compensate for the assumption of high risk in the company, the investor would be interested in earning a higher market interest rate on the securities or debts purchased.
It is worth emphasising that the interactions between demand and supply are not the only determinants of interest rates in the securities market; there are other equally compelling and significant factors that contribute to the effective determination of return (interest rate) on the investments of investors in the securities market. These other significant factors are couched in the risk inherent in the debt issuing firm.
Nominal interest rate: Generally, there is an interest rate that is commonly observed in the financial market. This is called a nominal interest rate. Inherent in a nominal interest rate is an expected inflation premium. Financial analysts make projections into the future; they determine prevailing economic conditions in the following year or several years. The projection often involves consideration for increased price of goods and services which may affect the value of an investment at the maturity date. To help maintain or increase the value of the investment at the maturity date, an inflation premium is factored into the final rate of interest that the debt issuer agrees to pay to the debt holder. Mathematically, the nominal interest rate with inflation premium is expressed as:
r = RR + IP (1)
Where:
r = Nominal interest rate
RR = Real interest rate
IP = Inflation premium
The nominal interest rate above is ideal for an organisation with no risk of payment default, that is, the organisation has the financial ability to pay debt holders at the maturity date. Debt issuers in this category are often governments.
However, some debt issuers cannot be immune from payment default. In this case, the debt holder may call for the inclusion of a default risk premium in the nominal interest rate. A default risk premium is the compensation a debt issuer provides to a debt holder for accepting to invest in the former’s organisation; it is the compensation to the debt holder for assuming the risk of non-payment of interest or non-payment of principal or both by the debt issuer at the maturity date. A nominal interest rate with a default risk premium is mathematically presented as:
r = RR + IP +DRP (2)
Where:
r = Nominal interest rate
RR = Real interest rate
IP = Inflation premium
DRP = Default risk premium
A nominal interest rate with inflation premium and default risk premium may not fall under the purview of government debts; it may be common among corporate debt issuers. As noted earlier, the investor may be interested in a higher interest rate to compensate for the risk assumed in the firm issuing the debts. The risk assumed by the investor (debt holder) up to this stage is considered moderate. However, operational and management challenges may impact negatively on a firm’s ability to repay its debts to holders when they become due; this increases the level of risk assumed by debt holders. In this regard, the debt holder would require higher compensation in the form of a higher market interest rate from the debt issuer. Thus, to avert any investment contingency in the short and long term, investment analysts include maturity risk premium and liquidity risk premium in the computation of the nominal interest rate:
r = RR + IP +DRP + MRP + LP (3)
Where:
r = Nominal interest rate
RR = Real interest rate
IP = Inflation premium
DRP = Default risk premium
MRP = Maturity risk premium
LP = Liquidity premium
The inclusion of maturity risk premium and liquidity premium in the computation of the nominal interest rate helps to protect debt holders against market fluctuations in the short and long term; the inclusion insures investors against possible loss of investment value at the maturity date.
Advertisement
The writer is the Lead Consultant/CEO
Eben Consultancy
Fellow Chartered Economist &
Council Member, ICEG
Email: [email protected]
Website: www.ebenezerashley.com