BUSI 2503 Chapter Notes - Chapter 10: Risk-Free Interest Rate, Risk Premium, Operating Leverage

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13 Aug 2016
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Chapter 10
What someone is prepared to pay for a financial asset (or security) is
referred to as its market value.
The market-determined required rate of return is the discount rate used for
the “time value” calculations, and depends on the market’s perceived level of
risk associated with an individual security.
Historically, the real rate of return demanded by investors has been about 2
to 3 percent
The inflation premium added to the real rate of return. The size of the
inflation premium is based on the investor’s expectations about future
inflation.
If one combines the real rate of return and the inflation premium, the risk-
free rate of return is determined. This the rat that compensates the investor
for the current use of his or her funds and for the loss in purchasing power
due to inflation, but not for taking risks.
We must now add the risk premium to the risk-free rate of return. This is a
premium associated with the special risks of a given investment.
Business risk relate to the possible inability of the firm to hold its
competitive position and maintain stability and growth in its earnings. We
can relate this to the firm’s capital assets and operating leverage.
Financial risk relates to the possible inability of the firm to meet its debt
obligations as they come due. This relates to the firm’s capital structure and
the maturity of its financial obligations.
Default risk: that the firm will not be able to meet its payment obligations as
promised
Liquidity risk: that there is a weak market for a firm’s securities, making it
difficult to sell them on a short notice
Maturity risk: that the value of the security will fluctuate due to the time until
final payment.
A bond contractually promises a stream of annuity payments (known as
interest or coupon) and a final payment (known as maturity, or face or par
value). Generally, the maturity value is $1000. In its most, common form, the
maturity value and coupon payments of a bond are fixed (cannot change) by
contract over the term of the bond.
The discount factor used to determine the price or present value is called
yield to maturity (Y). Yield, therefore, is the relationship between the price
investors are prepared to pay and future expected cash flows – in this case,
the coupon payments and the maturity value. The value of Y is determined in
the bond markets and represents the required rate of return demanded by
investors on a bond of given risk and maturity. Yield to maturity and the
interest (or coupon) rate are not the same thing.
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