Essay on Accounting: Interest and Bond

8255 Words Oct 10th, 2012 34 Pages
Part 3
Valuation of Securities
Chapters in this Part
Chapter 6

Interest Rates and Bond Valuation

Chapter 7

Stock Valuation

Integrative Case 3: Encore International

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 6
Interest Rates and Bond Valuation

Instructor’s Resources

This chapter begins with a thorough discussion of interest rates, yield curves, and their relationship to required returns. Features of the major types of bond issues are presented along with their legal issues, risk characteristics, and indenture convents. The chapter then introduces students to the important concept of valuation and demonstrates the impact of cash flows, timing, and risk on value. It explains
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We are informed that $383 billion is the 2009 interest expense and that the national debt was about $12 trillion in 2009 (i.e., $13 trillion less more than $1 trillion accrued in 2009). Division of the interest payment by the total debt results in an interest rate of
3.19 percent (i.e., $383 billion ÷ $12 trillion). Assuming the Treasuries are priced at par, one ends up with $31.90 per thousand being the annual payment needed to result in Treasuries being priced at par.
If interest rates rise by 1% to 4.19 percent, the price of the federal debt would fall to $955.71, as computed below.
N = 5, I = 4.19, PMT = 31.9, and FV = $1,000
Solve for PV = $955.71
The drop in Treasury values would be about 4.4 percent. This would decrease the size of the federal debt by $572 billion (0.044 × $13 trillion). Hence, if one considers the size of the current federal budget deficit in isolation, there is an incentive for the government to pursue policies which will lead to higher inflation. However, higher prices will lead to higher future costs for goods and services purchased by the government and an increase in the cost of entitlements, making proper use of interest rates to properly manage the federal budget difficult, complicated, and, alas, political.

Answers to Review Questions

1. The real rate of interest is the rate that creates an equilibrium between the supply of savings and demand for investment funds. The nominal
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