Lect 05 Fin 221 web

# Lect 05 Fin 221 web - Managerial Finance Lecture 5 Interest...

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1 Managerial Finance Lecture 5 Interest Rates and Interest Rates and Bond Valuation Class 4: Takeaways Internal Rate of Return (IRR) IRR: the interest rate that sets the NPV of cash flows equal to zero Common decision rule: invest if IRR > discount rate IRR is relevant as part of a comprehensive sensitivity analysis It is widely used and easy to communicate but ... It is unreliable as an investment decision rule When assessing consumer loans (mortgages, car loans, etc) Focus on the cash flows associated with each financing alternative 2 Make cash flows comparable by calculating their PVs Compute the PVs using your opportunity cost Never compare unadjusted cash-flows across periods Do not borrow or lend money if you do not understand the contract

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2 IRR Manipulation Assume you are asked to present a project to a client, who relies on the IRR, your final estimates are below: After the presentation, you learn that all approved projects need to have IRRs higher than 30% . What do you do? Year 0Y e a r 1Y e a r 2Y e a r 3 Disc. Rate NPV IRR Cashflows (100) 50 10% 24.3 23% 3 Year e a r e a r e a r 3 Disc. Rate NPV IRR Cashflows (35) 20 14.7 33% Implicit loan 65 (30) (30) (30) 9.6 to your client Your gain 65 30 9.6 Roadmap Bonds: Basic characteristics Yield curve Plot of bond yields as a function of the bond’s maturity date Determinants of bond prices: Interest rate sensitivity of bonds Law of one price: Identical cash flows paid at identical times must have the Identical cash-flows paid at identical times must have the same price 4
3 Bonds: valuation (fixed income) Bond: a borrowing arrangement in which the borrower issues (sells) an IOU to the investor Bonds are securities that promise to pay: A regular fixed coupon payment (if any)… … plus the principal value or face value at maturity Cash flows are all contracted (but not always riskless) Cash flows : (fixed income) Coupon bond : issuer makes (usually semiannual) interest payments Face value : principal paid at maturity (and notional amount to compute interest payments) Coupon rate: the coupon payment divided by the face value of the bond 5 Basic bond characteristics Different type of issuers Governments (U.S., etc…) Corporations (GE, Ford, etc …) Agencies (Fannie Mae, Freddie Mac…) Municipalities (New York City, etc…) Zero coupon bonds : no coupon payments US Treasury bonds: 6 Bills: Maturities between 1 and 12 months. No coupon payments. Notes: Maturities from 2 to 10 years. Coupon bonds. Bonds: Maturities > 10 years, up to 30. Also coupon bonds.

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4 Treasury Note Example 2-Year Treasury Note, \$100 million face value 0.25% coupon rate (semi-annual payments) Issued Sept 30 2011; due Sept 30 2013 Issued Sept 30, 2011; due Sept 30, 2013 This note is the 2-year on-the-run issue (the most recently issued note with a 2-year maturity) Sold for \$99.75277 (per \$100 face value) on Sept. 30, 2011 100.125 Cash flows if you bought this note on Sept 30, 2011: -99.75277 0.125 0.125 0.125 Sep 2011 Mar 2012 Sep 2012 Mar 2013 Sep 2013
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## This note was uploaded on 01/08/2012 for the course MS&E 245G taught by Professor Perez-gonzalas during the Fall '11 term at Stanford.

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Lect 05 Fin 221 web - Managerial Finance Lecture 5 Interest...

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