Bond pricing and equity valuations

Question 1

Describe the premise of the discounted cash flow model

Answer 1

Price = PV of all cash flows emanating from the holding of the bond

Question 2

What is income tax

Answer 2

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.

Question 3

What assumption do we make on income tax payments

Answer 3

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

Question 4

What is t1

Answer 4

Income tax rate

Question 5

What is t2

Answer 5

Capital gains tax rate

Question 6

Define capital gains tax

Answer 6

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).

Question 7

When is a capital gain made in a bond

Answer 7

If R>P a capital gain liability is incurred

Question 8

What happens when a bond makes a capital loss

Answer 8

If R < P then a capital loss is said to be made and in general no capital
gains tax liability will then be incurred.

Question 9

What assumption do we make for capital gains tax payments

Answer 9

Assume its incurred as a lump sum when the gain itself is realised. Cannot be deffered

Question 10

If R=P is there a capital gains tax liability

Answer 10

No

Question 11

What test must we use to check for incurance of capital gains tax if we do not know the price paid at the outset

Answer 11

CGT test

Question 12

If a capital gain is due to made at some future point how can the investor maximise their return

Answer 12

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

Question 13

If a capital loss is due to made at some future point how can the investor maximise their return

Answer 13

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

Question 14

What is more usual with bonds redeemable at various dates

Answer 14

Borrower has the option to redeem not the investor

Question 15

What is the consequence of having an option to redeem for the borrower for the investor of the bond

Answer 15

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.

Question 16

What might the borrower who has option to redeem base their decision on

Answer 16

Inflation
When they need the money
Optimal redemption

Question 17

Whats qs do we ask to analyse the invetsors options if the borrower has right to redeem

Answer 17

1. 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
2. What is the minimum net yield obtained by the investor if she pays a specified
   price?

Question 18

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

Answer 18

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

Question 19

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

Answer 19

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

Question 20

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

Answer 20

D(1+g)

Question 21

Define an undated bond

Answer 21

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.

Question 22

What is assumed about time periods n1 and n2

Answer 22

They are integer multiples of 1/p - bond will be redeemed on a coupon date

Question 23

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

Answer 23

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

Question 24

For equity or property investment when will a capital gain occur and what are the tax implications

Answer 24

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.

Question 25

Explain ex-dividend

Answer 25

A share which is offered for sale

excluding the next dividend is called ex-dividend or ‘xd’