LOS 2.a

Question 1

How to work out the PV of a fixed-income/equity instrument based on future cash flows

Answer 1

PV = FV (1+r)^t or FV (1+r)^-t
If continously compounding: FV x e^rt or PV = FV x e^-rt

e = Eulers number

Question 2

What is a pure discount debt instrument, and how to workout the PV and YTM of one

Answer 2

Definition: A pure discount debt instrument has no interest and instead the “interest earned” is the difference between the face value and purchase price.
Calculation for PV: PV = FV / (1+YTM)^years
Calculation for YTM: Enter into the calculator (put the price as a negative value)
In some circumstances, interest rates can be negative. A zero-coupon bond with a negative yield would be priced at a premium, which means its price is greater than its face value.

YTM= total rate of return earned by an investor at the end of period

Question 3

What is a fixed-coupon bond, and how to workout the PV and YTM of one

Answer 3

• Definiton: With a fixed coupon bond - investor recieves a cash interest payment each period in addition to the face value at maturity.
• Calculation: ((PMT/(1+YTD)+(PMT/1+YTD)^2……(PMT/1+YTD)^N)
• Calculation on calculator: N = Years, PMT = Coupon Payment, FV = Par value, I/Y = Interest rate = CPT PV

Question 4

What is a perpituity and how do you work out the PV of one

Answer 4

Defintion: Perpetuity is a bond that has no maturity date, we cannot calculte it’s future value meaningfully
Calculation: PV = payment / interest rate

Question 5

What is an amortizing bond and how do you make the annuity payment of it

Answer 5

Defintion: An amortizing bond payments a level amount each period, it differrs from a fixed coupon, in that it’s payment includes some portion of the principal.
Calculation: annuity payement = r x PV / ((1- (1+r)^t)
r = interst rate per period
t = number of periods
PV = present value (principal)
Caclulation on calculator: N = years, I/Y = interest rate, PV = -loan amount, FV = 0 - because the loan will be fully paid off after the last payment

Question 6

What’s the difference between equities and fixed-cinome

Answer 6

Equities securities do not mature, and their cash flows may change over time.

Question 7

What is preferred stock and how do you calculate it?

Answer 7

Definition: pays a fixed divident that is stated as a percentage of it’s par value (internal value, that it cannot be traded under)
Calculate: Dividend per period / markets required return on he preferred stock

Question 8

What is common stock

Answer 8

Common stock is a residual claim to the companies assets after it satisfies all over claims - no fixed divident payment

Question 9

How to calculate common stock if there’s a constant future dividend

Answer 9

Value it the same way as a preferred stock

Question 10

How to calculate common stock if there’s a constant growth rate of dividends

Answer 10

Apply the constant growth DDM
* P = D / (r-g)
* P = Value of a share this period // PV of all the dividents in future periods
* D = dividend expected to be paid next period
* r = required return on common equity
* g = constant growth rate of dividents.

Question 11

How to calculate common stock if there’s a changing rowth rate of dividends

Answer 11

The multistage Dividend Discount Model (DDM) handles changing dividend growth by breaking the valuation into two parts:

• Short Term: Discount each individual dividend expected during the initial high-growth period back to its present value.
• Long Term: Apply the constant-growth DDM to the first dividend that’s assumed to grow at a constant rate. This gives the value one period before that dividend. Then, discount this value back to the present.
• Finally, sum the present values of the short-term dividends and the discounted long-term value to get the total intrinsic value of the stock.

First period: 1 * Growth and 1 * Growth
Then use