Table of Contents
The Yield Curve
Yield curve is a curve that shows yields that are several or rates of interest across lengths of contracts that are different, for example, one year for a debt contract that is similar. It shows the relationship that exists between the rate of interest and the maturity time of a debt. The yield curve’s shape portrays the priorities that are cumulative of lenders to a specific borrower. Lenders are usually concerned with the default that is potential or increase in the rate of inflation. As result of this, they present loans that are long-term for rates of interest that are higher than those of the loans that are short-term.
What the Downward Sloping Yield Curve Suggest about Interest Rates for the Next 12 Months
The yield curve is a plot of bonds’ yields with terms of maturity, which are different, taking into consideration the risk profile that is uniform, tax, and liquidity. It also gives a description of the structure term and rates of interest for different bond types, for example, long-term bonds (Mishkin, 2001). Investors and economists believe that the yield curve’s shape shows the expectations of the future rates of interest in the market and monetary policy conditions. A downward sloping yield curve reflects that rates of interest that are long-term are below the rates that are short-term. The expectations hypothesis also suggest that when the slope of a yield curve is downward sloping, the average rates of interest expected in the future are below the rates that are short-term currently. This implies that in the future, the rates of interest that are short-term are expected to decrease on average.
I would recommend the company to use long-term bonds to get finance. The downward sloping curve reflects that the current rate of interest of the short-term bonds is high and it is expected to go down. Market participants and economists argue that when the rates of interest of short-term bonds decrease or when the slope is downward sloping, the long-term rates of interest decrease below the rates of interest that are short-term. The inverted or yield curve that is downward sloping implies that if the maturity of a bond is lower, the return available will also be down. This shows that investors are expecting a fall in the rates of interest of long-term rates. A downward sloping curve is sometimes seen as a sign of depression that is imminent (Mishkin, 2001).
If the curve flattens out, it will show that the rate of interest that is short-term is not expected to change on average in the future. A curve that is flat reflects that all maturities have yields that are similar. This reflects that the difference existing between the rates of interest that are short-term and long-term is relatively small. In this situation, I would recommend the company to use short-term bonds to finance the debt.
Opportunity Cost of Capital
This refers to the expected return that is forgone or not achieved by investing in a certain project rather than investing in other financial securities that are comparable. This implies that it is the difference in return that exists between an investment that one makes and another investment that one chose not to make. In most of the times, it occurs when trading in other decisions or in securities (Horngren, Datar, & Rajan, 2012). For example, if a person has two stocks to invest, stock A and B, and he/she has a certain amount of money, for example $20,000, the opportunity cost is realized when the person gets the difference in its returns. If the person invests $20,000 in stock A that has a return of 8% and fails to invest in stock B that has a return of 10%, the opportunity cost is 2% that is given by 10% minus 8%. There are different ways of conceptualizing opportunity cost, and one of the ways shows that it is the amount of money that a person could have made when choosing to make his/her investment in a decision that is different. The most important thing to note is that there is no actual loss in opportunity cost and it is not a risk type (Horngren, Datar, & Rajan, 2012).
The Importance of Opportunity Cost of Capital
The opportunity cost of capital is of great importance to different people and especially investors. This helps them in making decisions depending on how they value the level of returns and risks associated. Some investors like investing in securities that have high returns even if the risk associated is high. Another group of investors may like to invest in securities that have low risks, even if they are accompanied by low rates of return. Most of the investors prefer venturing their capital in prospect of higher rates of return than they can get by investing in firms that are publicly traded. Entrepreneurs’ similar attraction may be based on the prospect of returns that are higher than their financial and human capital. Some researchers show that the financial returns that are low are accepted by entrepreneurs because they also derive benefits that are non-pecuniary or have a value of skewness that is positive in returns of finance (Horngren, Datar, & Rajan, 2012). In order for the above cases to be rational, investors of venture capital and entrepreneurs must have anticipation of total returns that is in excess of opportunity cost of capital. Therefore, opportunity cost evidence is very critical to entrepreneurs and other people who do investment together with them. It is also helpful in comprehending their financial choices.