Module 2 Time Value of Money Flashcards
What is the Time Value of Money?
Represents the tradeoff between cashflow received today versus those received on a future date. The difference is based on an appropriate discount rate.
On what is the discount rate based?
Riskiness
How to calculate a discrete future value and present value?
FV = PV (1 + r) ^ t
PV = FV / (1 + r)^t
OR
PV = FV (1 + r) ^ -t
How to calculate a continuously compounding future value and present value?
FV = PV * e^rt
PV = FV * e^-rt
How to call the discount rate for fixed-income instruments?
Interest rate
How to call the rate of return for fixed-income instruments?
Yield-to-maturity
What are three patterns of cash flows associated with fixed-income instruments?
- Discount:
Investor pays single initial price (PV) and receives a single principal cash flow at maturity (FV). - Periodic Interest:
Investor pays initial price (PV) and receives interest cash flows (PMT) with the final interest payment and principal (FV) paid at maturity. - 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.
What is a zero coupon bond?
A bond in which an investor pays an initial price (PV) and receives a single principal cash flow at maturity (FV)
How to calculate the price of zero-coupon bond?
PV = FV / ( 1 + r ) ^ t
How to calculate the price of a coupon bond?
Discount each coupon payment and finally also the principal payment and add them up.
What happens to the price of a coupon bond when the coupon rate is equal to the YTM?
PV is equal to FV
What is a perpetual bond?
A coupon bond with no stated maturity
How to calculate the price of a perpetual bond?
PV = PMT / r, calculate like a perpetual
What are examples of fixed-income instruments with level payments?
Mortgages or annuities
How to calculate the periodic annuity cash flow?
( r * PV ) / 1 - ( 1 + r ) ^ -t
What is the difference between equity instruments and fixed-income instruments in terms of characteristics?
Equity instruments have no maturity
How to value company shares?
Discounting future cash flows (dividends and capital gains) using an expected rate of return
What are the three different dividend assumptions in valuing equity instruments?
Constant dividend
Constant dividend growth rate
Changing dividend growth rate
How to calculate the price of a share with constant dividend?
PV = D / r, using a perpetuity
How to calculate the price of a share with constant dividend growth?
D ( 1 + g ) / ( r - g )
What is the best way to compare equity prices instead of currency terms?
Price-to-earnings ratio (PE ratio)
What is PE ratio?
Price-to-earnings ratio measures a company’s share price relative to its earnings per share (EPS)
What is the dividend payout ratio?
The proportion of earnings distributed to shareholders as dividend
How to calculate the dividend payout ratio?
D / E
What is the forward price-to-earnings ratio?
Ratio of its share price to an estimate of its next period earnings per share
How to calculate the forward price-to-earnings ratio?
PE Ratio = Dividend Payout Ratio / r - g
What is the cash flow additivity principle?
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.
