5 Valuation of Bonds and Stocks Free Online FlashCards

What does financial asset valuation estimate?

Valuation estimates an asset’s value today by discounting its expected future cash flows.

What cash flows make up a conventional bond’s value?

A conventional fixed-rate bond’s value is the present value of its periodic coupon payments plus repayment of face value at maturity.

What does the dividend discount model value?

The dividend discount model estimates a share’s value as the present value of its expected future dividends.

How does estimated value differ from market price?

A model value is an estimate based on assumptions; a market price reflects buyers’ and sellers’ combined expectations and is not guaranteed to match that estimate.

How is a stream of future cash flows valued today?

The present value is $V_0=\sum_{t=1}^{n}\frac{CF_t}{(1+r)^t}$, where each cash flow is discounted by the rate for its period.

What must match when discounting cash flows?

The cash-flow timing and discount-rate periods must match; for example, annual cash flows require a rate expressed per year.

How is a bond’s price calculated from annual coupons?

For annual coupons, $P_0=\sum_{t=1}^{n}\frac{C}{(1+y)^t}+\frac{F}{(1+y)^n}$: discount each coupon and the face value at the bond’s required yield.

What helps determine a bond’s required market yield?

The required yield reflects factors such as prevailing interest rates and the issuer’s credit risk.

Why does the example bond sell below its $1,000 face value?

It sells below face value because its 6% coupon is less attractive than the 8% return available on comparable bonds.

How do bond prices respond to changes in market yields?

Bond prices and market yields move in opposite directions: a higher required yield lowers the present value of fixed payments, while a lower yield raises it.

When does a bond sell at par, above par, or below par?

A bond sells at par when its coupon rate equals its required yield, above par when the coupon rate is higher, and below par when it is lower.

What is the Gordon growth model, and what condition does it require?

The Gordon growth model is $P_0=\frac{D_1}{r-g}$. It assumes dividends grow at a constant rate forever and requires $r>g$.