Interest Rates and Security Valuation

INTEREST RATES AND SECURITY VALUATION
Chapter 3
VARIOUS INTEREST RATES MEASURES
COUPON RATE
• It is an interest rate on a bond instrument used to calculate the
annual cash flow the bond issuer promises to pay the bond
holder.
• The coupon rate on a bond instrument is the annual (or
periodic) cash flow that the bond issuer contractually promises
to pay the bond holder, this coupon rate is only one component
of the overall return (required, expected, or realized rate of
return) the bond holder earns on a bond, however, required,
expected, or realized rates of return incorporate not only the
coupon payments but all cash flows on a bond investment,
including full and partial repayments of principal by the issuer.
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.
The formula can be simplified as follows:
P = RFC1 + RFC2 + . . . RFCn
(1 + r)1 (1 + r)2 (1 + r)n
Where:
RFC = Realized cash flow in period t(t=1, . . .,n)
r = Realized rate of return on a security
If the realized rate of return (r) is greater than the required rate of return (r), the
market participant actually earned more than was needed to be compensated for
the expected risk of investing in the security.
If the realized rate of return is less than the required rate of return, the market
participant actually earned less than the interest rate required to compensate for the risk
involved.
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
BOND VALUATION
CALCULATION OF THE FAIR VALUE OF A COUPON BOND
SAMPLE PROBLEM: 1D CALCULATION OF THE FAIR VALUE OF A
COUPON BOND
You are considering the purchase of a $1,000 face value bond
issued by YOZECH Corporation. The bond pays 10% coupon
interest per year, with the coupon paid semi-annually (i.e.,P$50
(=1,000(0.10)/2) over the first half of the year and $50 over the
second half of the year.) The bond matures in 12 years (i.e., the
bond pays interest (12 x 2=) 24 times before it matures.) If the
required rate of return (rb) on this bond is 8% (i.e., the periodic
discount rate is (8%/2 = 4%), the market value of the bond is
calculated as follows:
Premium bond- a bond in which the present value of the bond is greater than its face value.
Discount bond- a bond in which the present value of the bond is less than its face value.
Par bond- a bond in which the present value of the bond is equal to its face value.
DESCRIPTION OF A PREMIUM, DISCOUNT AND PAR BOND
CALCULATION OF REALIZED RATE OF RETURN ON A STOCK
CALCULATION OF EXPECTED RATE OF RETURN ON A STOCK INVESTMENT
CALCULATION OF STOCK PRICE WITH ZERO GROWTH IN DIVIDENDS
CALCULATION OF STOCK PRICE WITH CONSTANT GROWTH IN DIVIDENDS
• CALCULATION OF THE EXPECTED RATE OF RETURN, E(rs), ON A STOCK WITH
CONSTANT GROWTH DIVIDENDS
CALCULATION OF STOCK PRICE WITH SUPERNORMAL OR NONCONSTANT
GROWTH IN DIVIDENDS

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INTEREST RATES AND SECURITY VALUATION

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

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

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

Consider again the Walmart bond investment described in Sample Problem 1A

890 = 100 + 100 + 925 r = 13.08%

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