Bond pricing and equity valuations Flashcards
Describe the premise of the discounted cash flow model
Price = PV of all cash flows emanating from the holding of the bond
What is income tax
Tax paid regularly on income received by the individual. In an
investment context this tax relates to regular income received by the investor in
respect of an asset held.
What assumption do we make on income tax payments
Paid at source when each
income payment is received by the investor. We ignore all forms of tax exemptions, tax-free allowances, indexation of tax
gains and offsetting of losses against gains
What is t1
Income tax rate
What is t2
Capital gains tax rate
Define capital gains tax
Tax paid on the realisation of a profit made by the investor
when an asset, or part of an asset, is disposed of (redemption, re-sale, maturity,
etc).
When is a capital gain made in a bond
If R>P a capital gain liability is incurred
What happens when a bond makes a capital loss
If R < P then a capital loss is said to be made and in general no capital
gains tax liability will then be incurred.
What assumption do we make for capital gains tax payments
Assume its incurred as a lump sum when the gain itself is realised. Cannot be deffered
If R=P is there a capital gains tax liability
No
What test must we use to check for incurance of capital gains tax if we do not know the price paid at the outset
CGT test
If a capital gain is due to made at some future point how can the investor maximise their return
The sooner
this gain is realised by the investor then the higher the investor’s net yield
will be - Investor should crystalise gains as soon as possible
If a capital loss is due to made at some future point how can the investor maximise their return
The later this
loss is realised by the investor then the higher the investor’s net yield will be. - defer capital losses as much as possible
What is more usual with bonds redeemable at various dates
Borrower has the option to redeem not the investor
What is the consequence of having an option to redeem for the borrower for the investor of the bond
The investor cannot know for certain at the outset when
redemption will actually take place. Investor will not know what price will give a certain yield and what yield will give a certain price.
What might the borrower who has option to redeem base their decision on
Inflation
When they need the money
Optimal redemption
Whats qs do we ask to analyse the invetsors options if the borrower has right to redeem
- What is the maximum price to be paid by the investor so as to obtain a certain
minimum net yield? - I want to obtain at least this yield - What is the minimum net yield obtained by the investor if she pays a specified
price?
What is the worst case scenario for the investor when there is a capital gain with flexible redemption between (n1 and n2 years) at the discretion of the borrower
Worst case is assume the redemption is at n2. If the bond is redeemed here we know the interest rate expected but if its redeemed before the interest rate will be better
What is the worst case scenario for the investor when there is a capital loss with flexible redemption between (n1 and n2 years) at the discretion of the borrower
Worst case is assume the redemption is at n1. If the bond is redeemed here we know the minimum interest rate expected but if its redeemed before the interest rate will be better
If divs are D, which has just been paid and all future divs will grow by g what is the first dividend you consider in pricing equation
D(1+g)
Define an undated bond
he latest possible redemption date is called the final redemption date
of the bond, and if there is no such date, then the bond is said to be undated.
What is assumed about time periods n1 and n2
They are integer multiples of 1/p - bond will be redeemed on a coupon date
If R==P on a bond with redemption date at the discretion of the borrower what course of action should they take to maximise annual net yield
there is neither a capital gain nor a capital loss on redemption. So, it will make no
difference to the investor when the bond is redeemed. The annual net yield will be i irrespective
of the actual redemption date
For equity or property investment when will a capital gain occur and what are the tax implications
if the
investor sells the equity or property holding at a future time-point for a larger value than for which
that holding was originally purchased, then a capital gains tax liability will arise for the investor.
Explain ex-dividend
A share which is offered for sale
excluding the next dividend is called ex-dividend or ‘xd’
