How to calculate rate of return?, Financial Management

Assignment Help:

Illustration

Consider a Rs.1,000 par value bond whose current market price is Rs.850. The bond carries a coupon rate of 8% and has a maturity period of 9 years. What would be the rate of return that an investor earns if he purchases the bond and holds till maturity?

Solution

The rate of return earned, also referred to as yield to maturity, is the value of kd in the following equation:

         P0               =     1034_rate of return.png

         Rs.850          =     821_rate of return1.png

                            =     Rs.80 (PVIFAkd%, 9 yrs) + Rs.1,000 (PVIFkd%, 9 yrs.).

Where,

         I        =   Interest

         F       =   Face value

         kd      =   Cost of debt

         P0      =   Current market price.

To find out the value of kd in the above equation, several values of kd will have to be tried out in order to reach the input value. Therefore, to start with, consider a discount rate of 12% for kd for which the expression becomes equal to:

         = Rs.80 (PVIFA 12%, 9 yrs) + Rs.1,000(PVIF12%, 9 yrs.)

         = Rs.80 x 5.328 + Rs.1,000(0.361)

         = Rs.426.24 + Rs.361 = Rs.787.24.

Since the above, value is less than the market price, we have to try with a less discounting rate (kd). So, let kd = 10%, then the equation becomes:

         = Rs.80(PVIFA10%, 9 yrs.) + Rs.1,000 (PVIF10%, 9 yrs.)

         = Rs.80 x 5.759 + Rs.1,000 x 0.424

         = Rs.460.24 + Rs.424 = Rs.884.72

From the above, it is clear that kd lies between 10% and 12%. Now, we have to use linear interpolation in the range of 10% and 12%. kd is determined as follows:

 

2292_rate of return2.png

                        = 10% + (12 - 10%)   2245_rate of return3.png   

 

                   = 10% + 2% 1276_rate of return4.png

 

                   = 10% + 2% x 0.356

                   = 10% + 0.71

                   = 10.71%

The yield to maturity is 10.71%.

An Approximation: As trial and error methods of calculation are tedious, the following approximation formula can be employed to find out the approximate YTM on a bond.

 

         YTM = 699_rate of return5.png       

 

Where,

           YTM          =     Yield to maturity.

                   I       =     Annual interest payment.

                   F       =     Par value or redemption value of the bond.

                   P       =     Current market price of the bond.

                   N       =     Years to maturity.

Therefore,

 

         YTM =         1053_rate of return6.png

                            615_rate of return7.png


Related Discussions:- How to calculate rate of return?

Pension fund system - uk, The UK Pension Fund System The UK Pension sys...

The UK Pension Fund System The UK Pension system is a three pillar pension system. A flat-rate first-tier pension is provided by the state and is known as the Basic State Pensi

Ledge ac count, Ask question #Minimum 100 words accepted

Ask question #Minimum 100 words accepted

What is installment credit, Q. What is Installment Credit? This is anot...

Q. What is Installment Credit? This is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in installments

find the worst case npv and probability, Question 1 What are the tota...

Question 1 What are the total cash inflows for project A? Discount rate (%)                      NPV of A (Rs.) 0

Financial accounting, Briefly explain the accounting concepts which guide t...

Briefly explain the accounting concepts which guide the accountant at the recording stage.

Current scenario of hedge fund industry, Global Scenario The Hedge Fund...

Global Scenario The Hedge Fund industry has captured over US $ 2 trillion in assets globally by the end of year 2006. According to an investor survey revealed for the Hedge Fun

Explain exchange rate risk, Explain Exchange Rate Risk Exchange-rate ri...

Explain Exchange Rate Risk Exchange-rate risk denotes to the risk the swap bank faces from fluctuating exchange rates throughout the time it takes the bank to lay off a swap it

Evaluation of credit policy, Q. What is Evaluation of Credit Policy? Ev...

Q. What is Evaluation of Credit Policy? Evaluation of Credit Policy: - A credit policy is prepared to maintain the investment in receivables at optimum level. Receivable Turnov

What is emerging issues task force, Q. What is Emerging Issues Task Force? ...

Q. What is Emerging Issues Task Force? Emerging Issues Task Force (EITF) - Assists FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) and provides guidance on early identification of

Types of financial investments, Question: (a) Give the four main types...

Question: (a) Give the four main types of financial investments and state the risks and bene ts associated to each type. (b) (i) Let k(t; T; s) denotes the return at time t

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd