FIN 345 1nd Edition Lecture 12Outline of Current Lecture1. Basic valuationa. Using time value of money concepts, we realize that the value of any asset is based on the present value of the cash flows the asset is expected to produce in the futureb. Asset value=(CF1/(1+r)1) + (CF2/(1+r)2) + L + (CFn/(1+r)n)i. CF1 = the cash flow expected to be generated by the asset in Period tii. R=the return investors consider appropriate for holding such an asset – usually referred to as the required return2. Valuation of Financial Assets – Bondsa. Bond is a long term debt instrumentb. Value is based on present value of:i. Stream of interest paymentsii. Principal repayment at maturityiii. Value: (can be found on financial calculator)iv. rd=required rate of return on a debt instrumentv. N=number of years before the bond maturesvi. INT=dollars of interest paid each yearvii. M=par or face value of the bond to be paid off at maturityviii. Vd=[INT/(1+rd)2 + INT/(1+rd)2 + L + INT/(1+rd)N] + M/(1+rd)Nix. =INT[ (1- (1 / (1+rd)N ) / rd ] + M/ (1+rd)Nx. Bond value = PV of an annuity of interest + PV of a lump sum payment at maturity3. Yield to Maturitya. YTM is the average rate of return earned on a bond if it is held to maturityi. Approximate yield to maturity=(annual interest + accrued capital gains) / average value of bond4. Yield to Calla. YTC is the average rate of return earned on a callable bond if it is held to the date of its first call5. Changes in Bond Values over Timea. When the rd (market rate) equals the coupon rate of interest, the bond will sell at its par valueb. Interest rates in the economy change continuouslyc. As interest rates change, so do the market values of bonds such that the rate of return earned by investing in a bond – that is, its YTM – is the same as the appropriate interest rate in the financial marketsThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.d. When market rates rise, bond prices decrease, and vice versae. When the market rate, rd, is equal to a bonds coupon rate of interest, the bondsmarket price equals its maturity (par) value and the bond is said to be selling atparf. When rd is greater than a bonds coupon rate of interest, the bonds market priceis less than its maturity value, and the bond is said to be selling at a discountg. When rd is less than a bonds coupon rate of interest, the bonds market price is greater than its maturity value, and the bond is said to be selling at a premiumh. The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupti. Return (yield) on a bondi. Bond yield=current (interest) yield + capital gains yieldii. =((INT/Vd,Begin) + ((VdEnd – VdBegin)/vdBegin))iii. INT= interest, VdBegin=beginning value of the bond, VdEnd=ending value of the bond6. Interest rate risk on a bonda. Interest rate price risk: the risk of changes in bond prices to which investors are exposed due to changing interest ratesb. Interest rate reinvestment rate risk: the risk that income from a bond portfolio will vary because cash flows have to be reinvested at current market