W1 Lecture INTEREST RATES AND BOND VALUATION v1 (1).pptx - INTEREST RATES BOND VALUATION Week 2 1F0120 Corporate Finance I Academic Department of

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INTEREST RATES & BOND VALUATION 1 Week 2 1F0120 Corporate Finance I Academic Department of Finance Universidad del Pacífico UNIVERSIDAD DEL PACIFICO 1F0120 W2 M. Gonzalo Chávez, CFA, CAIA, FRM
Outline I. The Internal Rate of Return (IRR) II. Interest Rates Quotes and Loans III. Determinants of Interest Rates IV. Bond Prices and Yields V. Corporate Bonds UNIVERSIDAD DEL PACIFICO 1F0120 W2 2
Internal Rate of Return (IRR) Internal Rate of Return (IRR) is the interest rate that sets the NPV of the cash flows equal to zero . It is a measure of the rate of return of an investment. The term internal refers to the fact that its calculation does not incorporate outside factors such as market interest rate. UNIVERSIDAD DEL PACIFICO 1F0120 W2 3
Example Suppose that you face an investment opportunity that requires a \$1000 investment today and will have a \$2000 payoff in six years, r = IRR = 12.25% Therefore, making this investment is equivalent to earning 12.25% per year on your money for six years UNIVERSIDAD DEL PACIFICO 1F0120 W2 4
Solving IRR of a Cash Flow Stream Consider a stream of cash flow, The IRR is calculated by solving the r in the NPV = 0 equation below, When N > 2 , the r may not be solved manually, we need to use a financial calculator or computer softwares (e.g. Excel). UNIVERSIDAD DEL PACIFICO 1F0120 W2 5
Outline I. The Internal Rate of Return (IRR) II. Interest Rates Quotes and Loans III. Determinants of Interest Rates IV. Bond Prices and Yields V. Corporate Bonds UNIVERSIDAD DEL PACIFICO 1F0120 W2 6
Effective Annual Rate (EAR) Effective Annual Rate (EAR) represent the actual amount of interest that will be earned at the end of one year . For example, if we are told that a \$100,000 investment has EAR 5%, we know that after one year we will have: after two years we will have: We can get a quick idea of the rate of return without going into the details of the compounding frequency. UNIVERSIDAD DEL PACIFICO 1F0120 W2 7
Discount Rate Conversion Note that, in the previous example, having an EAR 5% is the same as having a two-year interest rate of 10.25% . Similarly, an EAR of 5% is the same as having a six-month interest rate of r = 2.47%. In general, we can convert a discount rate of r for one period to an equivalent discount rate for n periods using the following formula: Note that n can be larger than 1 or smaller than 1. UNIVERSIDAD DEL PACIFICO 1F0120 W2 8
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