a. The value of an asset whose value is expected future cash flows is determined

Question

a. The value of an asset whose value is expected future cash flows is determined by the present value of all future cash flows the assets will generate. Given the case scenario and target audience provided, select and discuss a simple asset situation that could apply to exemplify this concept.

b. Select an example scenario appropriate to the seminar’s target audience Write a general expression for the yield on a probable debt security (rd) and define these terms in regards to that hypothetical security: real risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP).

Explanation / Answer

a. Example if there is an asset which produces cash flows of 1000, 1500 and 2000 in years 1,2 and 3. The present value of these cash flows at an discount rate of 10% would be

PV = 1000/1.10 +1500/1.10^2 + 200/1.10^3 = $2299.02

So Presenrt value = PV = $2,299.02

b. The general expression is:"

rd =r* + IP + DRP + LP + MRP

If for example a 10 year AA bond had the real interest rate is 1.5% = r*

The Infaltion premium = IP = 2%

The Default risk premium = DRP = 0.5%

The Liquidity premium = LP = 1.75%

The maturoty risk premium = MRP = 3.5%

The yield = 1.5 + 2 + 0.5 + 1.75 + 3.5 = 9.25%

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