Discounted cash flow (DCF) is a valuation method used to estimate the fair value of fixed-income securities by discounting their future cash flows to the present value.
Which of the following is NOT a factor in discounted cash flow analysis?
Not Correct
Correct!
Select an option above to see an explanation here.
A) Present value is the current value of a future cash flow, discounted at a specific rate. B) Future cash flow is the amount of money an investment is expected to generate in the future. C) Discount rate discounts future cash flows to their present value. D) Current yield is the annual income a bond generates, expressed as a percentage of its current market price, and is not a factor in discounted cash flow analysis.
What is the primary purpose of using discounted cash flow analysis for fixed income securities?
A) Discounted cash flow analysis is used to estimate the value of an investment based on its future cash flows, discounted to the present value. B) Calculating the annual income generated by a bond is not the primary purpose of discounted cash flow analysis. C) Measuring a bond's price sensitivity to changes in interest rates is not the primary purpose of discounted cash flow analysis. D) Assessing the risk that the issuer of a bond will default on its interest or principal payments is not the primary purpose of discounted cash flow analysis.
Which of the following best describes the relationship between the discount rate and the present value of a future cash flow?
A) As the discount rate increases, the present value of a future cash flow decreases, not increases. B) As the discount rate increases, the present value of a future cash flow decreases, as the future cash flow is worth less in today's dollars. C) The discount rate affects the present value of a future cash flow. D) The relationship between the discount rate and the present value of a future cash flow is predictable, with the present value decreasing as the discount rate increases.
In the early 2000s, investors used discounted cash flow analysis to evaluate the value of bonds a large telecommunications company issued. The study revealed that the company's bonds were overvalued, as their future cash flows did not justify their high market prices. This insight helped investors avoid significant losses when the company eventually filed for bankruptcy.
Become a Pro Member to see more questions
Example Series 65 Example Practice Question
An investor is considering purchasing a bond with a face value of $1,000, a coupon rate of 5%, and a maturity of 10 years. The investor can use discounted cash flow analysis to calculate the present value of the bond's future cash flows and determine whether the bond is fairly priced in the market.
DCF = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n Where: DCF = Discounted Cash Flow CF1, CF2, ..., CFn = Cash flows in each period r = Discount rate n = Number of periods
Suppose an investor is considering purchasing a 3-year bond with annual cash flows of $100 and a discount rate of 5%. Calculate the present value of the bond using the discounted cash flow formula. DCF = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + CF3 / (1 + r)^3 DCF = $100 / (1 + 0.05)^1 + $100 / (1 + 0.05)^2 + $100 / (1 + 0.05)^3 DCF = $100 / 1.05 + $100 / 1.1025 + $100 / 1.157625 DCF = $95.24 + $90.70 + $86.38 DCF = $272.32