Determining the appropriate rates in valuation process, Financial Management

After estimating the cash flows, the next step is to determine the appropriate interest rate that should be used to discount the cash flows. The minimum return required by an investor should be equal to the risk free rate of return plus risk premium. In  India , we can take yield on a 90-day Treasury bill as a risk-free rate. Any investor who invests in 90 days Treasury bill, will receive a return equal to risk-free rate. But the investors who invest in corporate bonds seek  some extra return over risk free rate for the additional risk are taking. This additional return is known as the risk premium.

So, appropriate rate is,

         Appropriate Rate = Risk Free Return + Risk Premium.

Mostly people use one interest rate of all estimated cash flows. However, since each cash flow is unique so it is better to use a unique interest rate for each cash flow.

Government paper with tenor more than one year is known as dated security. 

Posted Date: 9/10/2012 5:33:31 AM | Location : United States

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