Debt Test 2 - Test Two Time value of money o Valuation...

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Test Two Time value of money o Valuation requires the use of TVM operations Compounding Discounting o Future value: what a given amount of money in the present period is worth as a specified time in the future Pn = Po (1+r)^n N – number of periods Pn – future value n periods from now Po – original price R – int rate per period If interest is paid semiannually Both the interest rate and the number of periods used to compute the future value must be adjusted o R = annual int rate/number of times int is paid per year o N = number of times int is paid per year * number of years o Annuity – when the same amount of money is invested periodically Ordinary annuity – when the first investment occurs one period from now Annuity due – when the first investment is immediate Future value of an annuity – one way of calculating this would be to find the future value of each investment at the end of the investment horizon and then add these future values Pn = A[((1+r)^n – 1)/r] o A – amount of annuity o N – number of periods o R – int rate per period o Discounting The appropriate discount rate is the rate at which the money, in hand now, could be invested in order to produce the desired future value at a later date The “opportunity cost” rate, or the rate of return that you could earn on an alternative investment of similar risk PV = Pn [1/(1+r)^n] Present value of an ordinary annuity PV = A [(1 – {1/(1+r)^n})/r] o Pricing financial instruments Price of any financial instrument is equal to the PV of the expected CF’s Determining the price requires…
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An estimate of the expected CF’s An estimate of the required yield Pricing a zero coupon bond Zero coupon bonds do not make any periodic coupon payments, so the price is determined as follows… o P = M/(1+r)^n R = ½ the annual yield N = 2x the number of years In pricing bonds that pay semi-annual coupons, we assume that… when might these be violated??? The next coupon is exactly six months away o Purchased bond in the secondary market with first coupon coming less than 6 months from now The cash flows are known o Callable bonds – continuation of cash flows will depend on the level of current int rates relative to the coupon rate o Floating rate bonds – coupon rate is equal to a reference rate + quoted margin The appropriate required yield can be determined One rate is used to discount all cash flows o Accrued Interest Coupon interest earned from the time of the last coupon payment until the settlement date of the bond Computation of accrued interest Treasury coupon security – based on actual number of days the bond is held Corporate and municipal bond – based on 360 day year, with each month having 30 days Clean price – w/o accrued interest Dirty price – w/ accrued interest Measuring Yield o Internal rate of return
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Debt Test 2 - Test Two Time value of money o Valuation...

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