Finance 2 Flashcards
what is the simple formula for the current price of a share, P0
- P0 = (D1 + P1) / (1+r)
- D1 = dividend next year
- P1 = price next year
what is the dividend discount model (or the share price valuation model)
- P = Σ(t=1 to ∞) D_t / (1+r)^t
how does the dividend discount model change for constant dividend growth
- D1 remains constant but is multiplied by (1+g)^t-1
- so P =Σ D1*(1+g)^t-1 / (1+r)^t
how does the dividend discount model change for zero dividend growth
- zero dividend growth means D1 = D2 = D3 = ….
- so the model decays to just being the simple perpetuity model
what is the dividend growth model (gordon-shapiro model)
- P_n = D_n+1 / r - g
- given r > g
how does the dividend discount model change for non-constant dividend growth
- step 1: find the PV of dividends from year 1 to year n
- step 2: add the PV of the share price in year n
- step 3: discount step 2 and add step 1
what is a bond
- a bond is a ceritificate showing that the borrower owes a specific amount
what is the formula for the price of a bond, P_bond
- P_bond = C/(1 + YTM) + C/(1+YTM)^2 + … + C+F/(1+YTM)^n
- C = coupon = face value * coupon rate
- F = face value
- YTM = yield to maturity
how does the formula for the price of a bond change if the coupon is paid semi-annually instead of annually
- the C’s and YTM’s are divided by 2
when is a bond said to sell at a premium, discount or at par
- sell at a premium = when the bonds price is higher than its face value
- to sell at a discount = when the bonds price is lower than its face value
- to sell at par = the bonds price and face value are the same
what are the two forces that determine the yield-to-maturity
- central bank policy
- future expectations
how do central banks influence the YTM
- central banks use monetary yields to manage the economy by increasing or decreasing interest rates (the base rate)
- they can lower rates to stimulate economic activity or raise rates to cool down the economy
what is the yield curve
- a plot of the comparison between bonds with the same characteristics but different terms of maturities
- its basically a ratio of long-term bonds to short-term bills
what are the 4 types of risks that investors expose themselves to with bonds
- default risk
- liquidity risk
- regulatory risk
- interest rate risk
what is default risk
- the risk that a bond issuer will default on making the promised interest and principal payments to the buyer of the bond
what is liquidity risk
- the risk that a bond can be sold at a predictable price with low transaction costs on short notice
what is regulatory risk
- the risk that regulators will change the rules so as to adversely impact the earnings of the institution
what is interest rate risk
- the risk that volatility in the interest rate can change the value of the bond
- since bond holders receive a fixed coupon and will only realize all returns when the bond expires
which of the 4 types of risks are the most important and why
- interest rate risk
- because bond prices are affected whenever the government or central banks change interest rates
how are the prices of bonds influenced by a rise or drop in interest rates
- when interest rates go up, bond prices fall
- when interest rates go down, bond prices rise
what is the difference between growth shares and income shares
- for growth shares, investors expect to benefit from capital gains and are interested in future growth of earnings
- for income shares, investors seek cash dividends
what is the formula for payout ratio
- payout ratio = dividends / EPS
- EPS = earnings per share
what is the formula for earnings per share, EPS
- EPS = (net income - dividends to preferred shares) / average shares outstanding
what is the formula for return on equity, ROE
- ROE = net income / shareholders equity
what is the formula for plowback or retention ratio, b
b = 1 - payout
what is the formula for price earnings ratio, PER
- PER = market value per share / EPS
as a fund investing in growth stocks, what are the key factors you need to consider
- the factors that influence the growth rate of dividends, g
- and the net present value of growth opportunity, NPVGO
what is the formula for the growth rate of dividends, or capital gain yield, g
- g = b * ROE
- b = plowback ratio
- ROE = return on equity
what is the formula for the net present value of growth opportunity, NPVGO
- NPVGO = share price - EPS/r
