Valuation of Stocks and Bonds-Questions and Answers Graded A+

Valuation of Stocks and Bonds-Questions and Answers Graded A+ Value of a bond - ANSWER-equal to the present value of future interest payments plus the present value of par at maturity Capitalization of income method of valuation - ANSWER-states: the intrinsic value of any asset is based on the discounted value of the cash flows that the investor expects to receive in the future from owning the asset 3 criteria for bond analysis - ANSWER-bond's YTM = y bond's required rate of return = y* if y > y* the bond is undervalued if y < y* the bond is overvalued if y = y* the bond is said to be fairly priced Intrinsic value - ANSWER-inherent value of a bond NPV of bond can be calculated as the value of the bond and the purchase price NPV = V - P if V > P, if NPV is positive, then the bond is underpriced or undervalued and should be purchased if V < P, if NPV is negative, then the bond is overpriced or overvalued and should not be purchased Required rate of return - ANSWER-determining value of y* will depend on the investor's subjective evaluation of certain characteristics of the bond and current market conditions attributes of bonds used to help determine y*: coupon rate and maturity call and put provisions tax status (municipal vs taxable) marketability likelihood of default Capitalization of income-- stocks - ANSWER-price you are going to get when you sell your common stock is based on the future dividend payments the buyer expects while the stock is held plus some capital gains value of a share of stock should be the present value of its future dividends determining capitalization of income value of a share of common stock is 3 step process: estimate the future dividends, estimate the required return, discount the dividends back to present values at the required rate of return Net present value - ANSWER-NPV equation can be used to determine whether or not an investment is worthwhile investment is viewed favorable if its NPV is positive and unfavorable if its NPV is negative NPV = value - price equation to reflect a stock investment Internal rate of return - ANSWER-NPV is set to zero and the discount rate becomes unknown so it has to be calculated sometimes long-run IRR is referred to as the securitiy's implied return k* > k = favorable k* < k = unfavorable