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
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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
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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
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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
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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
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