The price of a security is the…?A the present value of all future cash flows....

The price of a security is the…?

A the present value of all future cash flows.

B sum of all future profits.

C the future value of all the future profits net of interest payments and taxes.

D the future value of all current dividends. geometric average of all past prices.

Solutions

Expert Solution

The Correct answer of this question is Option A i.e the present value of all the future cash flows.

Explanation :

The price of a security is the present value of all the future cash flows that the investor will receive by holding the security in the future. Suppose we take a example of a Bond which has a face value $ 100 and which has a coupon rate of 5 % and this bond is redeemable after 5 years , effective market interest rate (discount rate ) is 10 %. In this case we knows that we will receive $ 5 each year for the next five years as a coupon and will receive $ 100 at the end of 5 years after the redemption of the bond. To calculate the price of this bond today we need to find out the present values of cash flows today and for that we will discount these cash flows i.e. $ 5 coupons of five years and $ 100 with the effective interest rate i.e. 10% and the total of these present values will be the price of bond today.

Explanation for wrong answers:

All the three options are talking about future profits or future value of profits and cashflows but future values are not considered while calculation the price for today. We need to calculate today's price not the future's price therefore we needs to calculate the present value of benefits receive by paying the price of the security.

jeff jeffy answered 2 years ago

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