Rates of Return

So far, this chapter has illustrated how the valuation of any long-term financial instrument involves a capitalization of that security's income stream by a discount rate (or required rate of return) appropriate for that security's risk. If we replace intrinsic value in our valuation equations with the market price (P0) of the security, we can then solve for the market required rate of return. This rate, which sets the discounted value of the expected cash inflows equal to the security's current market price, is also referred to as the security's (market) yield. Depending on the security being analyzed, the expected cash inflows may be interest payments, repayment of principal, or dividend payments. It is important to recognize that only when the intrinsic value of a security to an investor equals the security's market value (price) would the investor's required rate of return equal the security's (market) yield.

Market yields serve an essential function by allowing us to compare, on a uniform basis, securities that differ in cash flows provided, maturities, and current prices. In future chapters we will see how security yields are related to the firm's future financing costs and overall cost of capital!