Module 2 Time Value of Money

Question 1

What is the Time Value of Money?

Answer 1

Represents the tradeoff between cashflow received today versus those received on a future date. The difference is based on an appropriate discount rate.

Question 2

On what is the discount rate based?

Answer 2

Riskiness

Question 3

How to calculate a discrete future value and present value?

Answer 3

FV = PV (1 + r) ^ t
PV = FV / (1 + r)^t
OR
PV = FV (1 + r) ^ -t

Question 4

How to calculate a continuously compounding future value and present value?

Answer 4

FV = PV * e^rt
PV = FV * e^-rt

Question 5

How to call the discount rate for fixed-income instruments?

Answer 5

Interest rate

Question 6

How to call the rate of return for fixed-income instruments?

Answer 6

Yield-to-maturity

Question 7

What are three patterns of cash flows associated with fixed-income instruments?

Answer 7

1. Discount:
   Investor pays single initial price (PV) and receives a single principal cash flow at maturity (FV).
2. Periodic Interest:
   Investor pays initial price (PV) and receives interest cash flows (PMT) with the final interest payment and principal (FV) paid at maturity.
3. Level Payments:
   Investor pays an initial price (PV) and receives uniform cash flows at pre-determined intervals through maturity which represent both interest and principal repayment.

Question 8

What is a zero coupon bond?

Answer 8

A bond in which an investor pays an initial price (PV) and receives a single principal cash flow at maturity (FV)

Question 9

How to calculate the price of zero-coupon bond?

Answer 9

PV = FV / ( 1 + r ) ^ t

Question 10

How to calculate the price of a coupon bond?

Answer 10

Discount each coupon payment and finally also the principal payment and add them up.

Question 11

What happens to the price of a coupon bond when the coupon rate is equal to the YTM?

Answer 11

PV is equal to FV

Question 12

What is a perpetual bond?

Answer 12

A coupon bond with no stated maturity

Question 13

How to calculate the price of a perpetual bond?

Answer 13

PV = PMT / r, calculate like a perpetual

Question 14

What are examples of fixed-income instruments with level payments?

Answer 14

Mortgages or annuities

Question 15

How to calculate the periodic annuity cash flow?

Answer 15

( r * PV ) / 1 - ( 1 + r ) ^ -t

Question 16

What is the difference between equity instruments and fixed-income instruments in terms of characteristics?

Answer 16

Equity instruments have no maturity

Question 17

How to value company shares?

Answer 17

Discounting future cash flows (dividends and capital gains) using an expected rate of return

Question 18

What are the three different dividend assumptions in valuing equity instruments?

Answer 18

Constant dividend
Constant dividend growth rate
Changing dividend growth rate

Question 19

How to calculate the price of a share with constant dividend?

Answer 19

PV = D / r, using a perpetuity

Question 20

How to calculate the price of a share with constant dividend growth?

Answer 20

D ( 1 + g ) / ( r - g )

Question 21

What is the best way to compare equity prices instead of currency terms?

Answer 21

Price-to-earnings ratio (PE ratio)

Question 22

What is PE ratio?

Answer 22

Price-to-earnings ratio measures a company’s share price relative to its earnings per share (EPS)

Question 23

What is the dividend payout ratio?

Answer 23

The proportion of earnings distributed to shareholders as dividend

Question 24

How to calculate the dividend payout ratio?

Answer 24

D / E

Question 25

What is the forward price-to-earnings ratio?

Answer 25

Ratio of its share price to an estimate of its next period earnings per share

Question 26

How to calculate the forward price-to-earnings ratio?

Answer 26

PE Ratio = Dividend Payout Ratio / r - g

Question 27

What is the cash flow additivity principle?

Answer 27

According to this principle, the present value of any stream of cashflows indexed at the same point equals the sum of the present values of the cash flows.