Why Interest Rates Are Different

Now, up until this point we’ve been pretending that you’ve been getting your money out of this minimum acceptable rate of return account that is of absolutely infinite size, well those kind of account don't really exist, or for the most part you are going to find that you are going to be collecting your fund that you'll be using for investment from a couple of different sources, or ultimately that your investment fund are strictly restricted ,either because you are a small business, you’re not. So what we are going to do now is discussing where you are getting this fund and what the structure of interest rate should look like and why they look that particular way.

So let’s start off with this diagram that we have right here which has on the vertical axis, right around over there, just the interest rate of any kind of investment that you have and on the horizontal axis. What we are looking at there is the scale of investment that you’re are going to make or the scale you are going to be borrowing from and so what we are going to be doing is pulling a trick, out of the single period choice criteria which is, in order to find the optimal pace, the optimal amount you should be investing in order to garner the largest benefit to you. You should be ordering your expenses, the sources of your fund from the cheapest to most expensive.

Lets outline first what the cheapest source of funds for you is going to be which also happens to be largest source of funds and that is going to be the funding that coming from retain earning and that is what your should think of this line as representing, this is your retain earning, now this is in the world the largest source of funds use for investing, the largest fund source of investment fund in the entire world. It’s true in the United states, it true in every single country you go to, this is where most of the funds for expansion occurs these tend to be the least expensive source fund primarily because the people that are making decision about how to use these funds are very tightly bound in with the business. They know exactly what projects they are working on, they know the strengths and the weaknesses of those projects, because they understand the business, and because they know you; they know your strengths and weaknesses and your sources of biases. So what I’m getting at is people that are evaluating these projects are the people that; because they have so much knowledge have a relatively smaller amount of uncertainty about what’s going to happen with this investment project.

What you are going to find is that when you are more uncertain your perception of risk if quite higher. Uncertainty is the way of saying you have some kind of risk there, although they aren’t exactly synonymous and if the risk is higher if the uncertainty be higher, normally that person requires a higher rate of return and what we are saying is that because these retain earning decision are made by people within the organization with lots of knowledge but they tend to have a lower risk evaluation and are willing to accept some slightly lower rate of return , so that’s the first and largest source of investment fund that you are going use.

The second source of fund, now that I’m going to just draw in right here; are bank loans. Now, bank loans are again the second largest source that goes right after these retained earnings and these are relatively low risk, because bankers will after some time will develop a lot of information and knowledge about both your particular firm and particular industry, you are going to find that the banker do specialize in specific industry and over time after you develop a reputation and relationship with the banker they are pretty aware of what you are doing and can describe it often well as you can. So these bank loans are the next largest source of fund, they also tend to be a little more expensive in terms of interest rate and then again just because they have less knowledge and are a little bit more uncertain about the eventual result.

Now, not exactly the final, but the source of fund that come afterward, is what you get out of the capital market. What we are talking about here are issuing some bonds and issuing some stocks and we going to kind of put on the same upper level that we have right over here. Now these are being regarded as being, you know, more uncertain, because if you’re trying to go ahead and talk to an investor that’s coming in from an outside, about a project. They don’t know all the individual in your firm that are engage in the project. They don’t know the real hard specific of your industry, they are coming as an outsider and they are going to have a lot of uncertainty. Classic response I can give you for this one is, some of you may own stock, go ahead and pick a share of stocks from one firm, anyone within your portfolio and tell me the where the nearest location is, unless it is going to be something like Intel, unless is going to be something like, you know, Columbia sportswear; you’re not going to know. Because you all don’t have that intimate knowledge that an insider would.

So what I’m trying to express to you is that your funds for investment are going to come from three different sources; first there is the retained earnings, the second one and slightly more expensive fund are going to be things like bank loans, and the third largest sources is going to be the capital market and this means new issuance of stocks and new issuance of bonds, we’ll get to why the return on those kind of assets tends to be about the same.

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