Need responses to these discussions:
Describe what happens to the present value ofa cash flow stream when the discount rate increases?
1. Present value iswhat is required for an investor to put into a security today in order toreceive the expected return. “Discounting is used to describe the process ofcalculating present values.” When the rate of discounting goes up it is a goodthing for the present value since it means less is required to be put down inorder to reach that final amount. For instance, in a scenario where the personwants 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 meanthey would need to put down $370.37 compared to$377.36. It isn’t a huge difference when looking at the example I gave butthis could mean hundreds of dollars if the time is alonger maturity and/or larger amount they want to reach at the end ofmaturity.
2. Hello everyone
The yield difference between the corporate bonds and treasury bonds of thesame maturities is known as yield spread. Treasuries are considered as risk freeas they are backed by the government. The return on corporate bond is higherthan the return on the treasury bond, as corporate bond is more risky and thereis greater chances of company’s default. The higher the corporate bond’s creditrating, the lower the bond’s yield spread and the lower the rating the greaterthe yield spread. So, if the bond rating is high, its yield spread is low, andif 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 andcurrent market value is $42, which shows that current market price is higherthan the intrinsic value of the preferred stock. It is not favorable to buy thatpreferred stock as future cash flows are lower than expected. If this preferredstock is purchased, then in future this might return to its original price whichis lower than the current market price and has to suffer a loss. So,Laissez-Faure’s preferred stock should not be purchased.
The general rule in economics is that the value of money today will not beequal to the same amount of money in the future. It is also know as time valueof money, this is a central concept in the finance theory which takes intoaccount, factors such as interest rates and inflation. When calculating returnsover time, it is important to keep this in perspective and know the differencebetween nominal returns (returns on paper) and real returns (adjusted fortoday’s purchasing power). Investors are more concerned with the real returnsthan the nominal returns on their investments because a real rate o return isthe annual percentage return realized on an investment which is adjusted forchanges in prices due to inflation or other external effects. This keeps thepurchasing power of a given level of capital constant over time. The investorsare usually concerned about the after tax returns that they will get as the taxliability can vary substantially.