Valuation of Securities: Interest Rates and Bond Valuation

Interest rates and required returns embody the real cost of money, inflationary expectations, and issuer and issue risk. They reflect the level of return required by market participants as compensation for the risk perceived in a specific security or asset investment. Because these returns are affected by economic expectations, they vary as a function of time, typically rising for longer-term maturities. The yield curve reflects such market expectations at any point in time. The value of an asset can be found by calculating the present value of its expected cash flows, using the required return as the discount rate. Bonds are the easiest financial assets to value; both the amounts and the timing of their cash flows are contractual and, therefore, known with certainty (at least for high-grade bonds). The financial manager needs to understand how to apply valuation techniques to bonds, stocks, and tangible assets (as we will demonstrate in the following chapters) to make decisions that are consistent with the firm’s share price maximization goal.

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