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1、Valuation and Rates of Return,10,1-2,Chapter Outline,Valuation of assets, based on the present value of future cash flowsThe required rate of return in valuing an asset is based on the risk involvedBond valuation and its determinationStock valuation and its determinationPrice-earnings ratio,1-3,Valu
2、ation of Financial Assets,1-4,Valuation Concepts,Valuation of a financial asset is based on determining the present value of future cash flowsRequired rate of return (the discount rate)Depends on the markets perceived level of risk associated with the individual securityIt is also competitively dete
3、rmined among companies seeking financial capitalImplying that investors are willing to accept low return for low risk and vice versaEfficient use of capital in the past results in a lower required rate of return for investors,1-5,Valuation of Bonds,A bond provides an annuity stream of interest payme
4、nts and a principal payment at maturityCash flows are discounted at Y (yield to maturity).Value of Y is determined in the bond market.The price of the bond is:Equal to the present value of regular interest paymentsDiscounted by the yield to maturity added to the present value of the principal,1-6,Va
5、luation of Bonds (contd),Assuming interest payments ( ) = $100; principal payments at maturity ( ) = $1,000; yield to maturity (Y) = 10% and total number of periods (n) = 20. Thus, the price of binds ( );Where: = Price of the bond; = Interest payments; = Principal payment at maturity; t = Number cor
6、responding to a period (running from 1 to n); n = Number of periods; Y = Yield to maturity (or required rate of return),1-7,Present Value of Interest Payments,To determine the present value of a $100 annuity for 20 years, with a discount rate of 10%We have:,1-8,Present Value of Principal Payment (Pa
7、r Value) at Maturity,Principal payment at maturity is used interchangeably with par value or face value of the bondDiscounting $1,000 back to the present at 10%, we have:The current price of the bond, based on the present value of interest payments and the present value of the principal payment at m
8、aturity:Here, the price of the bond is essentially the same as its par, or stated value to be received at maturity of $1,000,1-9,Relationship Between Bond Prices and Yields,Bond prices are inversely related to bond yields (move in opposite directions)As interest rates in the economy change, the pric
9、e or value of a bond changes:if the required rate of return increases, the price of the bond will decreaseif the required rate of return decreases, the price of the bond will increase,PPT 10-8,1-10,Bond price and required rate of return(yield to maturity),If the market rate is higher than the coupon
10、 rate (the annual interest payment divided by the par value), the bond will sell at discount (below par value)If the market rate is equal to the coupon rate, the bond will sell at par valueIf the market rate is lower than the coupon rate, the bond will sell at premium ( above par value),1-11,Concept
11、 of Yield to Maturity,The yield to maturity or the discount rate is the required rate of return required by bondholdersThree factors influence the required rate of return:Required real rate of returnInflation premiumRisk premium,1-12,Concept of Yield to Maturity,Real rate of return:Demanded by the i
12、nvestor against current use of the funds on a non-adjusted basisInflation premium: Compensation towards the negative effect of inflation on the value of a dollarRisk free rate of return compensates for the use of funds and loss due to inflationRisk Premium: Towards special risks of an investment,1-1
13、3,Risk Premium (contd),Business Risk: inability of the firm to retain its competitive position and stability and growthFinancial risk: inability of the firm to meet its debt obligations as and when dueAssuming the risk premium is 3%, an overall required rate of return of 10% can be computed;,1-14,In
14、crease in Inflation Premium,Assume this goes up from 4 to 6%, with everything else being constantPresent value of interest payments: $100 annuity for 20 years at a discount rate of 12%;,1-15,Increase in Inflation Premium (contd),Present value of principal payment at maturity: Present value of $1,000
15、 after 20 years at a discount rate of 12%;Total present value: Assuming that increase inflation increases required rate of return and decreases the bond price by $150 approximately,1-16,Decrease in Inflation Premium,Assuming that the inflation premium declines:The required rate of return decrease to
16、 8%, where the 20 year bond with a 10% interest rate would now sell for;Present value of interest payments,1-17,Decrease in Inflation Premium (contd),Present value of principal payment at maturity Total present value,1-18,Bond Price Table,1-19,Time to Maturity,Influences the impact of a change in yield to maturity on valuationLonger the maturity, the greater the impact of changes in yield,
