C12 - Valuation of Investments

Question 1

Describe historic book value, written up/down book value

Discuss their relevance to liability valuation

Answer 1

Historic book value is the price originally paid for the assets and often used for fixed assets in published accounts

Written up/down book value is historic value adjusted periodically for market movements

Neither or these are of use for consistent to liability valuation because an appropriate discount rate for the liability valuation cannot be determined

Question 2

Smoothed asset value

Answer 2

+ Avg of MV over a specified period
+ Removes daily fluctuations
- Not consistent to liability valuation
- DR Cannot be determined and requires judgement

Question 3

Fair value of assets

Answer 3

Amount for which as asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms length or transaction
- Does not specify how such a value is calculated

Question 4

Discuss the use of discounted cashflow method

Answer 4

Discounted Cashflow Method

Discounting the expected future CFs from an investment using long term assumption
+ Method is consistent with a discounted cashflow approach to valuing liabilities
+ Stable, if assumptions are not changed too frequently
+ Employs actuarial judgement, so can adjust out influence of market sentiment
- Subjective choice of assumptions e.g. discount rate
- Time consuming
- Not well understood by clients

Question 5

Discuss the use of stochastic models in asset valuation

Answer 5

Uses discounted cashflow method
Future cashflows (or interest rate) would be treated as random variables with a specified probability distribution
Uses computer simulation
Output is a distribution of results from which expected asset value and volatility can be calculated
Appropriate in complicated cases

Question 6

Arbitrage value

Answer 6

Proxy market value
Calculated by replicating investment with a combination of other investments and applying the condition that in an efficient market (ie arbitrage free) the values must be equal
Technique often used in valuing derivatives

Question 7

What does modern finance theory suggests about market value

What is the counter argument

Answer 7

Where an efficient market exists, the resulting market value
1. will reflect all publicly available information
2. and is the underlying ‘economic value’ of the asset at any given time

Question 8

Describe how bonds may be valued

Answer 8

• Government – discount cashflows using market spot yields (ideally, term specific yields would be used for cashflows of different terms)
• Corporate – adjust yields upwards for security and marketability
• Bonds with embedded options can be valued using option pricing techniques

Question 9

Describe 5 methods for valuing equity

Answer 9

1. Market value
2. Discounted dividend model
   V = D / (i - g)
   V = value of the share
   D = dividend in exactly one years time
   i = investor’s required rate of return
   (often yield on long-term bond plus an addition for riskiness of the income stream)
   g = dividend growth rate
   Assumptions:
   Dividends are paid annually with the next payment in one year’s time
   i and g constant i > g
   Tax and expenses ignored
   Share held in perpetuity
   Dividends reinvested at the same rate i
3. Net asset value
   Value of underlying assets of company / no. of ordinary shares
4. Measurable key factor approach
   -Involves determining a relevant and measurable key factor for the company’s business.
   -Relationship between this factor and the market price of other quoted companies is then used as a basis for valuation
   -Factor used will depend on the particular business of the company
5. Shareholder value
   Looks at one year’s results and the cost of capital supporting those results
   Attempt at getting an intrinsic value of an investment (rather than accounting value)

Question 10

Describe how discounted CF techniques can be used to value property

Answer 10

Discounted cashflow:
A suitable discount rate is government bond yield of a suitable term plus margin to reflect risks associated with property:
-Lack of marketability
-Risk of voids
-Default risk
-Volatility of market value
-Illiquidity
-Depreciation and obsolescence
-Costs (if not allowed for explicitly in the cashflows)

CFs should be net of all outgoings and allow for expected rental increases.

Question 11

How are future and options normally valued?

Answer 11

• Usually valued using techniques based on principle of ‘no arbitrage’
• Value taken is the cost of closing out the contract by buying an equal and opposite option or future at current terms

Question 12

How are swaps valued?

Answer 12

• Discounted cashflow of income - outgo
• Sum of the series of forward arrangements