Chapter 3 - Time value of money. After studying chapter 3, you should be able to: Understand what is meant by “the time value of money"; understand the relationship between present and future value; describe how the interest rate can be used to adjust the value of cash flows – both forward and backward – to a single point in time;. | Chapter Three Interest Rates and Security Valuation 3- McGraw-Hill/Irwin Various Interest Rate Measures Coupon rate periodic cash flow a bond issuer contractually promises to pay a bond holder Required rate of return (rrr) rates used by individual market participants to calculate fair present values (PV) Expected rate of return (Err) rates participants would earn by buying securities at current market prices (P) Realized rate of return (rr) rates actually earned on investments 3- McGraw-Hill/Irwin Required Rate of Return The fair present value (PV) of a security is determined using the required rate of return (rrr) as the discount rate CF1 = cash flow in period t (t = 1, , n) ~ = indicates the projected cash flow is uncertain n = number of periods in the investment horizon 3- McGraw-Hill/Irwin Expected Rate of Return The current market price (P) of a security is determined using the expected rate of return (Err) as the discount rate CF1 = cash flow in period t (t = 1, , n) ~ = indicates the projected cash flow is uncertain n = number of periods in the investment horizon 3- McGraw-Hill/Irwin Realized Rate of Return The realized rate of return (rr) is the discount rate that just equates the actual purchase price ( ) to the present value of the realized cash flows (RCFt) t (t = 1, , n) 3- McGraw-Hill/Irwin Bond Valuation The present value of a bond (Vb) can be written as: M = the par value of the bond INT = the annual interest (or coupon) payment T = the number of years until the bond matures i = the annual interest rate (often called yield to maturity (ytm)) 3- McGraw-Hill/Irwin Bond Valuation A premium bond has a coupon rate (INT) greater then the required rate of return (rrr) and the fair present value of the bond (Vb) is greater than the face value (M) Discount bond: if INT 3- McGraw-Hill/Irwin Equity Valuation The present value of a stock (Pt) assuming zero growth in dividends . | Chapter Three Interest Rates and Security Valuation 3- McGraw-Hill/Irwin Various Interest Rate Measures Coupon rate periodic cash flow a bond issuer contractually promises to pay a bond holder Required rate of return (rrr) rates used by individual market participants to calculate fair present values (PV) Expected rate of return (Err) rates participants would earn by buying securities at current market prices (P) Realized rate of return (rr) rates actually earned on investments 3- McGraw-Hill/Irwin Required Rate of Return The fair present value (PV) of a security is determined using the required rate of return (rrr) as the discount rate CF1 = cash flow in period t (t = 1, , n) ~ = indicates the projected cash flow is uncertain n = number of periods in the investment horizon 3- McGraw-Hill/Irwin Expected Rate of Return The current market price (P) of a security is determined using the expected rate of return (Err) as the discount rate CF1 = cash flow in period t (t = 1, ,
