Discounted Cash Flow Valuation Flashcards
With a pure discount instrument, like a zero-coupon bond, the investor pays
less than the face value to buy the instrument and receives the face value at maturity
The price that the investor pays for a pure debt instrument depends on the instrument’s
Yield to Maturity, (which is the discount rate applied to the face value) and the time until maturity
On the calculator it is important to enter cash outflows as… and cash inflows as….
Outflows such as purchase price or PV (Present Value) as negative values
and Inflows such as the return of the face value at maturity or FV (Future Value) as positive values
With a Fixed-Coupon Bond, the investor receives
a cash interest payment each period in addition to the face value at maturity
The bonds’s Coupon Rate is a
Percentage of the face value and determines the amount of the interest payments.
Ex: a 3% annual coupon, $1,000 bond pays 3% of $1,000, or $30 a year
What are the functions (N, I/Y, PV, PMT, FV)
Zero Coupon Bond with face value at $1,000 with mature in 15 years, yield to maturity of 4%
N=15
I/Y=4
PV= cpt
PMT=0
FV=1,000
What are the functions (N, I/Y, PV, PMT, FV)
10 years, $1,000 par value, 10% coupon, annual-pay bond, yield to maturity is 8%
N=10
I/Y=8
PV=cpt
PMT=100 or 10% of $1,000
FV= 1,000
Some bonds exist that have no maturity date. These are referred to as
Perpetual Bonds or Perpetuities
The present value of Perpetuity, or a Perpetual Bond is
Payment (PMT)
________________
I/Y
An Amortizing Bond is one that pays
a level amount each period, including its maturity period.
Ex: Annuities
The difference between an Amortizing Bond and a Fixed-Coupon Bond is
for an Amortizing Bond, each payment includes some portion of the principal. With a Fixed-Coupon Bond, the entire principal is paid to the investor on the maturity date
What are the functions (N, I/Y, PV, PMT, FV)
“Suppose you are considering applying for a $2,000 loan that will be repaid with equal end-of-year payments over the next 13 year. If the annual interest rate for the loan is 6%, how much are your payments?
N=13
I/Y=6
PV=-2,000
PMT=cpt
FV=0
The key difference between Fixed-Income securities and Equity securities are that
Equity securities do not mature, and their cash flows may change over time
Preferred Stock pays
A fixed dividend that is stated as a percentage of its Par Value (similar to the face value of a bond)
We say that equity investors have a required return that will induce them to own an equity share. This required return is the…
Discount rate we use to value equity securities
Preferred stock’s fixed stream of dividends can be considered infinite and therefore their value can be determined by
Dividing dividends per period by the markets required return on the preferred stock
Annual dividend
__________________
I/Y
Because the future cash flows are uncertain, we must use models to estimate the value of common stock. The three approaches endless use frequently, are called
Dividend Discount Models (DDM)
1) Assume a constant future dividend
2) Assume a constant growth rate of dividends
3) Assume a changing growth rate of dividends
Under the assumption that we Assume a Constant Future Dividend, we can
Value a common stock the same way we value a preferred stock, using the perpetuity formula
Under the assumption that we Assume a Constant Growth Rate of Dividends, we can
apply the Constant Growth DDM, aka. The Gordon Growth Model
Present value =
Dividends expected to be paid out
____________________________________
required return - dividends expected growth potential
Under the assumption that we Assume a Changing Growth Rate of Dividends, we can
use a Multistage DDM. Essentially, we assume a pattern if dividends in the short term, such as a period of high growth, followed by a constant growth rate id dividends in the long term
If the required yield is greater than the coupon rate, the present value of the bond will be…
less than their face value
