Finance

6.5 What is the intrinsic value of a security and why do we focus on intrinsic values in finance?

The intrinsic value of a security is the present value of expected future cash flows. Cash flows are forecast and then discounted at the investor’s required return. Intrinsic value is the appropriate value for finance because it applies the principles of the time value of money.

6.6 Describe the variables that are used to determine a security’s intrinsic value and explain the role of each variable.

The basic security valuation equation is:

It states that the intrinsic value of a security is a function of the size and timing of the cash flows that will be generated by the security. The cash flows are discounted to reflect the time value of money. The discount rate used is the investor’s required return. If the security can be purchased for less than its intrinsic value, the investor will earn more than his required return.

6.10 What is a zero coupon bond? Is the calculation of the intrinsic value of a zero coupon bond different from that for a coupon bond? Explain.

A zero coupon bond does not have any coupon payments over its term to maturity. This means that interest is paid via the difference between the purchase price and the maturity value of the bond. Coupon bonds do receive regular interest payments over their lives plus the payment of face value at maturity. The implication for valuation is that the intrinsic value of a zero coupon bond is the PV of its face value. The intrinsic value of a coupon bond, on the other hand, is the present value of the face value plus the present value of the coupon payments over the bond’s life.

6.12 If dividends are paid semi-annually on a preference share and we adjust the required return to reflect this, is the intrinsic value any different to a share with the same total dividend paid annually and an annual required return? Use an annual dividend of $1 and a required return of 9% to demonstrate your...