Chapter3 - Chapter Three Security Valuation MGMT 109...

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1 Chapter Three Security Valuation MGMT 109 Managerial Finance Professor Lu Zheng The First Principle of Security Valuation • The price of a security is equal to the present value of its cash flows, where the interest or discount rate is the return that can be earned on alternative investments with the same characteristics (similar cash flows). Bonds • The most straightforward type of investments to value are bonds, because the payments to a bond are promised and fixed. • While default is a possibility, we are now only going to look at riskless bonds , where we can be sure of the payout.
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2 Discount Bonds • The simplest kind of bond is called a discount bond or a zero coupon bond . This kind of bond has only one cash payment, equal to the face value of the bond when the bond is redeemed. – A Treasury Bill is an example of this kind of bond. DISCOUNT BONDS • The price of a discount bond is P = (Face Value) PF(r,n) × () = Face Value 1+r n Example: Discount Bond • Suppose that you want to find the price of a discount bond that pays $100,000 in exactly two years. If the interest rate on similar bonds is 6%, then the bond price should be
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3 Coupon Bonds • The other common type of bonds is a coupon bond. • These bonds pay periodic payments called coupons and also a balloon payment equal to the face value of the bond. Coupon Bonds • Further, these bonds are typically quoted with a percentage equal to the yearly coupon. – For example, a 10% bond means that 10% of the face value is paid each year as a coupon. • Most of these bonds pay coupons semi-annually , which means that the 10% coupon bond pays 5% of the face value every six months. Pricing Coupon Bonds P = PV(Annuity) + PV(Face) Where C = annual interest = Coupon rate×Face Value F = the bond's face value r = APR for similar bonds n = number of years to maturity × × C PAF r nFP F r n 22 2 2 2 ,,
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4 Example: Pricing a Coupon Bond Consider a $1,000 face value default free government bond. Suppose that the bond has an 10% coupon and 12 years to maturity. Finally, suppose that the interest rate on similar bonds is 4%. This 4% is the APR, given semi annual compounding. Yield To Maturity • Suppose you purchase this bond at P0 = 1,567. What rate of return will you earn on your investment?
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Chapter3 - Chapter Three Security Valuation MGMT 109...

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