The Discount Rate - Essay Example

Firms whose securities are in high demand will experience a decline in their discount rates.
b) Product 1 rate of return
The total dividend in a year= is 1.5*4=6
Year 1 rate of return= 1+discount/nominal price*100
=1+6/100*100%=7%
Year 2-4 rater of return= 6/100*100%=6%
Year 5 rate of return= 6+6.4/100*100%=12.4%
Average rate of return= ((7+6+6+6+12.4)%)/(5 Years)
=7.48%
Product 2 rate of return= nominal interest rate
=6%
Product 3 rate of return
Year 1 rate of return=(7-2(premium))/100*100%= 5%
Rear 2 and 3 return= nominal rate = 7%
Product rate of return= ((5+7+7))/3=6.33%
Product 1 looks more attractive because it has the highest rate of return compared to products 2 and 3.
c) In making the decisions, it is important that an investor consider the duration of the investment as this will determine the net present value. The longer the investment period, the less attractive the worth of the investment because of the time value of cash flows (Bierman & Smidt, 2004).
d) (I) The real value of the investment is the present value of future cash flows. In this case, the inflation rate is used and the discounting rate and since there is nonpayment of a coupon on the investment, the value of the investment will be the present value of £100 after 10 years
Real value=100/((1+0.04)^10)-100
=£ (32.44)
The present value of the coupons to be paid for the 10 years= is 32.44
(ii)The coupon payment =32.44/PVIFA =32.44/8.1109 = £4
The coupon rate should be 4% per annum i.e. the coupon rate should be equal inflation the annual inflation rate.
In conclusion, before determining which investment to pursue, factors like inflation, time, and general economic conditions are important. Read More