Professional Documents
Culture Documents
The principle of time value of money the notion that a given sum of money is
more valuable the sooner it is received, due to its capacity to earn
interest is the foundation for numerous applications in investment
finance.
The Five Components Of Interest Rates
Real Risk-Free Rate This assumes no risk or uncertainty, simply
reflecting differences in timing: the preference to spend now/pay back
later versus lend now/collect later.
Expected Inflation - The market expects aggregate prices to rise, and
the currency's purchasing power is reduced by a rate known as the
inflation rate. Inflation makes real dollars less valuable in the future and
is factored into determining the nominal interest rate (from the
economics material: nominal rate = real rate + inflation rate).
Default-Risk Premium - What is the chance that the borrower won't
make payments on time, or will be unable to pay what is owed? This
component will be high or low depending on the creditworthiness of the
person or entity involved.
Liquidity Premium- Some investments are highly liquid, meaning they
are easily exchanged for cash (U.S. Treasury debt, for example). Other
securities are less liquid, and there may be a certain loss expected if it's
an issue that trades infrequently. Holding other factors equal, a less
____________________
1 + inflation rate
Effective Annual Interest Rate: Interest rate that is annualized using compound interest.
Theeffective annual yield represents the actual rate of return, reflecting all of the compounding
periods during the year. The effective annual yield (or EAR) can be computed given the
stated rate and the frequency of compounding.
Effective annual rate (EAR) = (1 + Periodic interest rate)m 1
Where: m = number of compounding periods in one year, and
periodic interest rate = (stated interest rate) / m
Example:Effective Annual Rate
Suppose we are given a stated interest rate of 9%, compounded monthly, here is what we
get for EAR:
Annual Percentage Rate (APR): Interest rate that is annualized using simple interest rate.
The effective annual rate is the rate at which invested funds will grow over the course of a
year. It equals the rate of interest per period compounded for the number of periods in a
year.
Keep in mind that the effective annual rate will always be higher than the stated rate if there
Future Value:
Definition: The value to which a beginning lump sum or Present Value (PV) will grow in a certain
number of periods, n, at a specified rate of interest, i.
Formula:
FV = PV (1 + i)n
Where: i = the stated rate of interest
n = number of years
(1 + i)n = the future value interest factor
Compound Interest: Interest earned on interest.
Simple Interest: Interest earned only on the original investment; no interest is earned on interest.
Example: In six years, Frank will be eligible for membership in the elite Flat lounger Club. A lifetime
membership will cost him $14,000. Frank currently has $11,000 in a savings account that
pays an annual interest rate of 4.2 percent. In six years, will he have enough money in the
account to pay his membership fees?
When compounding occurs more than once a year
Example: Jane has inherited $4,500 dollars, and she has decided to deposit it in her savings
account for six months before she decides how to spend/invest it. If Janes savings account
pays 3 percent compounded monthly, how much money will she have in six months?
Compound growth means that value increases each period by the factor (1 + growth rate).
The value after t periods will equal the initial value times (1 + growth rate)t. When money is
invested at compound interest, the growth rate is the interest rate.
(1 + r)n
r
Annuity Due: Level stream of cash flow starting immediately.
We know that if you were to save $1 each year your funds would
accumulate to
Future value of annuity of $1 a year = (1 + r)t 1 = (1.10)50 1
_________
__________
= $1,163.91
r
0.10
Therefore, if we save an amount of $C each year, we will accumulate $C
1,163.91.
We need to choose C to ensure that $C 1,163.91 = $500,000. Thus C =
$500,000/1,163.91 = $429.59. This appears to be surprisingly good news.
Saving
$429.59 a year does not seem to be an extremely demanding savings
program. Dont
celebrate yet, however. The news will get worse when we consider the
Problems
Assume that it is now January 1, 1997 and you will need $ 1,000 on January 1,
2001. Your bank compounds interest at an 8% annual rate.
How much must you deposit on January 1, 1998, to have a balance of $
1,000 on January 1, 2001?
If you want to make equal payments on each January 1 from 1998 through
2001 to accumulate the $ 1,000, how large must each of the 4 payments
be?
If you have only $ 750 on January 1, 1998, what interest rate, compounded
annually, would you have to earn to have necessary $ 1,000 on January 1,
2001?
Suppose you can only deposits the stream of payments only $ 186.29 each
January 1 from 1998 through 2001, but you still need $ 1,000 on January 1,
2001. What interest rate compounded annually must you seek out to
achieve your goal?
Strategic Financial
Management
Bond Valuation
Negative Covenants
Negative convents are the restraints put on a borrower.These restraints
include issuing additional securities or taking on additional debt that may
harm the current bondholders.This is generally done without meeting
certain tests and/or ratios or receiving permission from the current
bondholders.
Did you notice that the coupon payments on the bond are an
annuity? In other words, the holder of our 6 percent Treasury
bond receives a level stream of coupon payments of $60 a
year for each of 3 years. At maturity the bondholder gets an
additional payment of $1,000. Therefore, you can use the
annuity formula to value the coupon payments and then add
on the present value of the final payment of face value:
PV = PV (coupons) + PV (face value)
= (coupon annuity factor) + (face value discount
factor)
Problem:
Calculate the present value of a 6-year bond with a 9 percent
coupon. The interest rate is 12 percent?
FIGURE
Yield to Maturity (YTM): Interest rate for which the present value of the
bonds payment equals the price. The yield to maturity is defined
as the discount rate that makes the present value of the
bonds payments equal to its price. Price The value of the 6
percent bond is lower at higher discount rates. The yield to maturity
is the discount rate at which price equals present value of cash flows.
Call Price - This is the price that the issuer will pay the bondholder;
also know as the redemption price.
Call Date - This is the date or dates that the issuer can call the bond
from the holders.
Strategic Financial
Management
Stock Valuation
Security Valuation
The Top-Down Approach
The top-down approach is a valuation approach that begins
with first analyzing the overall economy and then
continuing to drill down to the specific analysis.The idea
behind the top-down approach when valuing securities is to
start from a high level analysis: the general economic
conditions. The next step would then be to analyze a
specific industry within the economy.Last, an investor
would compare and analyze specific securities to invest in.
The top-down approach allows an investor to make an
informed investment decision based on a keen
understanding of the economy and industry and how that
relates the stock, versus comparing the stocks
fundamentally against their peers without thinking about
the overall movement in the market.
The top-down approach can be particularly useful when
analyzing the valuation of world stocks.Given the starting
point of understanding the world economies, an investor is
able choose an appropriate stock based on areas of the
world that may be doing better.a
(0.10-0.03)
The value of Newcos common stock is as follows:
Newcoscs = $0.265+ $0.281 + 0.289 + $4.252 =
****
(1.10)1 (1.10)2 (1.10)3 (1.10)3
Supply and demand are driven by rational factors, such as data and
economic analysis, as well as irrational factors, such as guesses.
Shifts in supply and demand will shift the trends in the market and
can be detected in the market.
Technical vs. Fundamental Analysis
The main difference between technical analysis and fundamental
analysis is the use of financial statements to value equities. Technical
analysis is the practice of valuing stocks on past volume and pricing
information.Technical analysis combines both the use of past
information (how stocks have reacted previously) and feeling (how
the market is moving the name) to value a security.
Fundamental analysis, however, takes a more formal
approach.Fundamental analysts review the financial statements of a
company and generate metrics, such as price-to-book value and
enterprise value-to-EBITDA to value a security.