Topic 2 Valuation Of Financial Instruments Flashcards
(22 cards)
What is a financial instrument for valuation purposes?
A claim on a stream of future cash flows held by an investor.
Why do we estimate the present value of a financial instrument?
To determine the value today of all future cash flows.
What does the market price of an asset reflect?
The market’s valuation of the asset.
What can comparing your valuation to the market price indicate?
Whether the asset is under- or over-valued, suggesting a buy/sell decision.
What is the time value of money?
The concept that money today is worth more than the same amount in the future.
Why is a euro today more valuable than a euro in the future?
Because of impatience and opportunities to invest the money today.
What is a discount factor?
A percentage used to reduce the value of future cash to present value.
What does a higher discount factor mean?
A smaller reduction in the value of future cash.
What does a lower discount factor mean?
A greater reduction in the value of future cash.
What is the basic present value (PV) formula?
PV = Σ [CFt / (1 + r)^t] where CFt is the cash flow at time t and r is the discount rate.
What happens to present value when the discount rate increases?
The present value decreases.
What happens to present value when the discount rate decreases?
The present value increases.
Where might a discount rate come from?
It may be based on an interest rate, like the yield on government bonds.
Why might a discount rate be higher than the interest rate?
To reflect impatience, uncertainty, or credit risk.
What is a ‘safe asset’ in discounting?
An asset with a known return, like a government bond or deposit account.
What is a pure discount bond?
A bond that pays a fixed amount at maturity with no coupon payments.
What is a perpetual bond?
A bond that pays a coupon every year forever.
What are the components of equity cash flows?
Annual dividend payments and the sale price of the shares.
What is the implied discount rate?
The rate derived from market price and cash flows using the PV formula.
What is the yield on a bond?
The market’s implied internal rate of return.
How do interest rates affect asset prices?
Lower interest rates increase present value, raising asset prices.
What is meant by the phrase ‘discounting to get present value’?
Reducing future cash flows to their equivalent value today using a discount rate.
