MODULE 2.1: Discounted Cash Flow Valuation

Question 1

What is a pure discount instrument?

Answer 1

when you recieve a discounted price on an equity that has a maturity date. At this maturity date, you should receive the full face value of this equity. A common example is a zero coupon bond. For example, buy a zero coupon for 750 and after 15 years, receive the full amount of 1000

Question 2

Fixed Coupon bond

Answer 2

here, the investor not only recieves a discounted rate, and a face value at maturity, but also a coupon payment at a periodic basis.

Question 2

pure discount instrument calculations

Answer 2

can use calculator to give is the PV, FV, i/y, N . There is no PMT for this since there are no coupons.

Manual calculation:
FV = PV (1+ r) ^ t

Question 3

fixed coupon bond calculation

Answer 3

same as the pure discount but we now have the par value and the PMT rate which would be the rate on the par value.

ex) - Consider a 10-year, $1,000 par value, 10% coupon, annual-pay bond. What is the value of this bond if its yield to maturity is 8%?
1. PMT = Coupon payments = .10(1000) = $100 annually as a coupon
2. I / Y = 8 (written as the whole percentage number and NOT .08)
3. n = 10
4. FV = 1000
5. need to calculate the present value here
1. PAR VALUE IS THE FACE VALUE

Question 4

perpetual bonds or perpetuities definition

Answer 4

bonds that do not have a maturity date. They will keep on paying a certain coupon rate

Question 5

Amortizing bond meaning

Answer 5

This is an annuity instrument where there is a maturity date and a periodic payment. In this payment, a certain percentage of the principle is paid, so when the bond reaches maturity, the face value has already been paid in the periodic payments.

Think if house mortgage payments

Question 6

perpetual bonds PV calculation

Answer 6

PV = payment / r

Question 7

amortizing bond formula for annuity payment and explanation for it

Answer 7

value = PV x r / 1 – ( 1+r ) ^ -t

The key here is the PV x r which his multiplying the present value by the interest rate. Thsi calculates the principal amount .

We then divide it by the rate over time to finally get the annuity payment

Question 8

Equity Securities

Answer 8

a security that does not guarentee a regular payment and the underlying value will fluctuate with time. They do not mature.

Key phrase: present value of future cash flows

Question 9

Preferred Stock Meaning

Answer 9

equity given to you by a company that has a regular payment based on the par value (10% or a par value of 1000 for example). Par value does not change but the underlying security can change. This is like a dividend

Question 10

common stock meaning

Answer 10

there is no par value based return to be given to you as a requirement. Based on the company books, they may choose to give you some dividend. The underlying security will fluctuate with time.

Question 11

preferred stock value calculation

Answer 11

value = Dividend per period / required return for stock

Question 12

Common stock value calculation

Answer 12

dividend / required return - constant growth rate of dividends

Question 13

Multistage DDM

Answer 13

changing growth rate of dividents - the value if there are changing growth rates. We assume that there will later be a period of constant growth over the long term.

Also known as the Gordon Growth Model:

The Gordon growth model, also known as the constant growth dividend discount model (DDM), takes the next period’s dividend and divides it by the difference between the required return and the growth rate. The growth rate is assumed to be constant, and it must be below the required return—or else the denominator of the calculation will be negative, making it invalid.

Question 14

Multistage DDM calculation

Answer 14

Question 15

To determine whether the current price of a common stock is aligned with its intrinsic value, an analyst wants to use the Gordon growth model. To appropriately apply the model, the analyst will need to estimate:

Answer 15

the dividend to be received next year.

Question 16

Continuously compounded rate of return formula and meaning

Answer 16

ln (1 + REF) = stated rate (continuously compounded rate)

Question 17

The continuously compounded rate of return that will generate a one-year holding period return of -6.5% is closest to:

Answer 17

Continuously compounded rate of return = ln(1 – 0.065) = -6.72%.

Question 18

A loan of $15,000 is to be paid off in monthly payments over 5 years at 12% annual interest. What is the amount of each payment?

Answer 18

WE NEED TO ADJUST ALL THE NUMBERS FOR MONTHLY SINCE WE ARE PAYING IN MONTHLY PAYMENTS

I –> 12% annually means, calculator already does the math on this one for 1% monthly

N = 5 x 12 –> This is the number of periods there are. 5 years and 12 months gives us the number of months

PV = 15000 –> value of the loan amount now
CPT pmt

FV = 0 –> since there will not be any loan left at the end of the period

CPT PMT since we need to calculate the payment

answer is - 333.67

Question 19

1) Compute the present value of a perpetuity with $100 payments beginning four years from now. Assume the appropriate annual interest rate is 10%.

Answer 19

Use pv=c/r formula but take it back in time 3 years with the PV=FV(1+r)t formula

751.30

Question 20

An equity investor has a required return of 7% and purchases preferred stock with a $50 per share par value and an annual dividend of $3.20. The value of the preferred stock is closest to:

Answer 20

Around 45

Question 21

An investment product promises to pay a lump sum of $25,458 at the end of 9 years. If an investor feels this investment should produce a rate of return of 14%, compounded annually, the present value is closest to:

Answer 21

7,828.54

Question 22

4) A share of George Co. preferred stock is selling for $65. It pays a dividend of $4.50 per year and has a perpetual life. The rate of return it is offering its investors is closest to:

Answer 22

6.92%

Question 23

5) To determine whether the current price of a common stock is aligned with its intrinsic value, an analyst wants to use the Gordon growth model. To appropriately apply the model, the analyst will need to estimate:

Question 24

6) Assume that one- and two-year risk-free rates are 1.80% and 2.50%, respectively. Using the cash flow additivity principle, the one-year reinvestment rate, one year from now is closest to:

Answer 24

3.20%.

Question 25

7)An investor looks at her monthly brokerage statement and notices that the yield to maturity on her 5-year corporate bond with a 4% annual coupon rate has gone from 4.2% last month to 3.8% this month. The statement will reflect a bond price that, over the last month, has:

Answer 25

When the yield to maturity (YTM) on a bond decreases, the price of the bond increases because bond prices and yields have an inverse relationship.