Interest Rates and Security

Valuation
Various Interest
Rate Measures
01 Coupon Rate

02 Required Rate of
Return

03 Expected Rate of
Return

04 Realized Rate of
Return
 Defenition
Required rate of return
Coupon rate interest rate an investor
interest rate on a bond should receive on a security
instrument used to given its risk. Required rate of
calculate the annual return is used to calculate the
cash flows the bond fair present value on a
issuer promises to pay security.
the bond holder.
 Required Rate of
Return
FPV = CF1 + CF2 + CF3 +…+ CFn
(1 + rrr)1 (1 + rrr)2 (1 + rrr)3 (1 + rrr)n

Where: rrr = Required rate of return

CF1 = Cash flow projected in period t (t = 1, …, n)
~ = Indicates that projected cash flow is uncertain
(due to default and other risks)
n = Number of periods in the investment horizon
 Example
A bond you purchased two years ago for $890 is now
selling for $925. The bond paid $100 per year in
coupon interest on the last day of each year (the last
payment made today). You intend to hold the bond for
four more years and project that you will be able to sell
it at the end of year 4 for $960. RRR is 11.25 per cent.
b. 11.6O7
c. 9.45
d. 9.95
 Activity
The bond paid $150 per year in coupon interest on the
last day of each year (the last payment made today).
You intend to hold the bond for three more years and
project that you will be able to sell it at the end of year
3 for $860. You also project that the bond will continue
paying $150 in interest per year. Given the risk
associated with the bond, its required rate of return ( r )
over the next three years is 9.5O percent. Accordingly,
the bond’s fair present value is
 Activity
The Morrissey Company's bonds mature in
7 years, have a par value of $1,000, and
make an annual coupon payment of $70.
The market interest rate for the bonds
is 8.5%. What is the bond's price?

a $923.22
.
b $946.30
.
c $969.96
.
 Defenition
Expected rate of return
interest rate an investor
expects to receive on a security
if he or she buys the security at
its current market price,
receives all expected
payments, and sells the
security at the end of his or her
investment horizon.
Realized rate of return
actual interest rate earned on
an investment in a financial
security. Realized rate of
return is a historical (ex post)
measure of the interest rate.
 Expected Rate of
P = CF1 + CF
Return
+ CF +…+ CF
2 3 n
(1 + Err)1 (1 + Err)2 (1 + Err)3 (1 + Err)n

Where: Err = Expected rate of return

CF1 = Cash flow projected in period t (t = 1, …, n)
~ = Indicates that projected cash flow is uncertain
(due to default and other risks)
n = Number of periods in the investment horizon
Expected\Realized Rate
of Return
PP - BP
Approx. YTM= AIP + N .
.6(BP) + .4 (PP)
Where: YTM = Yield to Maturity
AIA = Annual Interest Payments
PP = Principal Payments (Par Value of the Bond)
BP = Bond Price (Current Price of the Bond)
N = Number of periods in the investment horizon
 Activity
A bond you purchased two years ago for $890 is now
selling for $925. The bond paid $100 per year in
coupon interest on the last day of each year (the last
payment made today). You intend to hold the bond for
four more years and project that you will be able to sell
it at the end of year 4 for $960.
b. 11.6O7
c. 9.45
d. 9.95
 Activity
What is the approximate yield to maturity for
a $1,000 par value bond selling for $1,120
that matures in 6 years and pays 12 percent
interest annually?
(a) 8.5 percent
(b) 9.4 percent
(c) 12.0 percent
(d) 13.2 percent
 Activity
Mugwump Industries has issued a bond which has a
$1,000 par value and a 15 percent annual coupon
interest rate. The bond will mature in ten years and
currently sells for $1,250. Using this information, the
yield to maturity on Mugwump’s bond is _________.
(a) 10.79 percent
(b) 11.39 percent
(c) 12.19 percent
(d) 13.29 percent
 Activity
Compute for the YTM given the following:

Par Value of Bond: P1,OOO

Ineterest Rate: 1O%
Term: 1O years
Current Price P9OO
Stock with Zero Growth in Dividends
Assignment
Using the formula, compute for the current stock price:
rs = D/P0 rs= rate of return
D = Dividend
Po= Stock Price
A preferred stock you are evaluating is expected to pay a
constant dividend of $1O per year each year into the
future. The expected rate of return, E(r s ) , on the stock is
15 percent.
Stock with Constant Growth in
Dividends

rs= rate of return

D = Dividend
Po= Stock Price
g= growth rate
Stock with Constant Growth in
Dividends
A stock you are evaluating paid a dividend at the
end of last year of $3.50. Dividends have grown at a
constant rate of 2 percent per year over the last 20
years, and this constant growth rate is expected to
continue into the future. The required rate of return
(r s ) on the stock is 10 percent. The fair present
value (or price) of this stock is P44.63
Stock with Constant Growth in
Dividends

NOTE: D1 is the value of the stock

after one year.
For the second formula, on the next
slide, I will give you an example
Stock with Constant Growth in
Dividends
Reddick Enterprises' stock currently sells for $35.50
per share. The dividend is projected to increase at a
constant rate of 5.50% per year. The required rate of
return on the stock, rs, is 9.00%. What is the stock's
expected price 3 years from today?