Question description
Need responses to these discussions: Describe what happens to the present value of
a cash flow stream when the discount rate increases?
1. Present value is
what is required for an investor to put into a security today in order to
receive the expected return. “Discounting is used to describe the process of
calculating present values.” When the rate of discounting goes up it is a good
thing for the present value since it means less is required to be put down in
order to reach that final amount. For instance, in a scenario where the person
wants to earn $400 in 1 year but has an option of either an interest rate of 6%
or 8%, the person should choose the higher percentage since 8% would only mean
they would need to put down $370.37 compared to
$377.36. It isn’t a huge difference when looking at the example I gave but
this could mean hundreds of dollars if the time is a
longer maturity and/or larger amount they want to reach at the end of
maturity.2. Hello everyone
The yield difference between the corporate bonds and treasury bonds of the
same maturities is known as yield spread. Treasuries are considered as risk free
as they are backed by the government. The return on corporate bond is higher
than the return on the treasury bond, as corporate bond is more risky and there
is greater chances of company’s default. The higher the corporate bond’s credit
rating, the lower the bond’s yield spread and the lower the rating the greater
the yield spread. So, if the bond rating is high, its yield spread is low, and
if the bond’s rating is low, then the yield spread is high.
The firm’s preferred stock is overvalued as its intrinsic value is $40 and
current market value is $42, which shows that current market price is higher
than the intrinsic value of the preferred stock. It is not favorable to buy that
preferred stock as future cash flows are lower than expected. If this preferred
stock is purchased, then in future this might return to its original price which
is lower than the current market price and has to suffer a loss. So,
Laissez-Faure’s preferred stock should not be purchased.
3. The general rule in economics is that the value of money today will not be
equal to the same amount of money in the future. It is also know as time value
of money, this is a central concept in the finance theory which takes into
account, factors such as interest rates and inflation. When calculating returns
over time, it is important to keep this in perspective and know the difference
between nominal returns (returns on paper) and real returns (adjusted for
today’s purchasing power). Investors are more concerned with the real returns
than the nominal returns on their investments because a real rate o return is
the annual percentage return realized on an investment which is adjusted for
changes in prices due to inflation or other external effects. This keeps the
purchasing power of a given level of capital constant over time. The investors
are usually concerned about the after tax returns that they will get as the tax
liability can vary substantially.
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