INTEREST RATES AND SECURITY VALUATION

Chapter 3
SAMPLE PROBLEM 1A: Application of Required Rate of Return
A Walmart 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. You also project that the bond will continue paying $100 in interest per
year. Given the risk associated with the bond, its required rate of return (r) over the next four years
is 11.25 percent. Accordingly, the bond’s fair present value is:

PV = 100 + 100 + 100 + 100 + 960 = $ 935.31

(1 + 0.1125)1 (1 + 0.1125)2 (1 + 0.1125)3 (1 + 0.1125)4

Given the current selling price of the Walmart bond, $925, relative to the fair present value,
$935.31, this bond is currently undervalued.
SAMPLE PROBLEM 1B: Application of Expected Rate of Return

Refer to information in Sample Problem 1A describing a Walmart bond you

purchased two years ago for $890. Using the current market price of $925, the
expected rate of return on the bond over the next four years is calculated as
follows:

925= 100 + 100 + 100 + 100 + 960 E(r) = 11.607%

[1 + E(r)]1 [1 + E(r)]2 [1 + E(r)]3 [1 + E(r)]4

Given that the required on the bond is 11.25 percent, the projected cash flows on
the bond are greater than is required to compensate you for the risk on the bond.
SAMPLE PROBLEM 1C: Application of Realized Rate of Return

Consider again the Walmart bond investment described in Sample Problem

1A and 1B. Using your original purchase price, $890, and the current market price
on this bond, the realized rate of return you have earned on this bond over the
last two years is calculated as follows:

890 = 100 + 100 + 925 r = 13.08%

(1 + r)1 (1 + r)2