Gustavo Antonio Rangel Torres 1648938 Team 6

Valuation and Rates of Return

The valuation of a financial asset is based on determining the present value of future cash flows. Thus we need to know the value of future cash flows and the discount rate to be applied to the future cash flows to determine the current value. The market-determined required rate of return, which is the discount rate, depends on the market's perceived level of risk associated with the individual security. Also important is the idea that required rates of return are competitively determined among the many companies seeking financial capital.

As previously stated, the value of a financial asset is based on the concept of the present value of future cash flows. Let's apply this approach to bond valuation. A bond provides an annuity stream of interest payments and a $1,000 principal payment at maturity. These cash flows are discounted at Y, the yield to maturity.

The value of Y is determined in the bond market and represents the required rate of return for bonds of a given risk and maturity. More will be said about the concept of yield to maturity in the next section. The price of a bond is thus equal to the present value of regular interest payments discounted by the yield to maturity added to the present value of the principal (also discounted by the yield to maturity).

The yield to maturity, or discount rate, is the rate of return required by bondholders. The bondholder, or any investor for that matter, will allow three factors to influence his or her required rate of return

The value of a share of common stock may be interpreted by the shareholder as the present value of an expected stream of future dividends.

Stock Valuation Based on Future Stock Value The discussion of stock valuation to this point has related to the concept of the present value of future