Market Values

The market value of any asset is the sum of the present value of cash flows expected to be generated by the asset. Several factors determine the expected values of these cash flows. Some of these factors include the discount rate applied, timing, and the magnitude of these future cash flows as well as risk premiums.

Expected Cash Flows

The value of an asset typically depends on the benefits that one is expecting to receive from holding it. For assets such as financial securities, these benefits can only be observed from their future cash flows. Generally, money received in the future is not equivalent to money received today. The value will be less than the current value. Investors defer their cash consumption to the future and thus require an incentive for the deferment, plus the unpredictability of the future. The present value of an asset is therefore computed by discounting its future cash flows.

The following is a basic discounted cash flow model:

$$ \text{Market value}=\sum_{t=1}^{n}\frac{CF_t}{\left(1+r\right)^t} $$

Where:

• \(n\) is the term of the asset.
• \(CF_t\) is the cash flow at time \(t\).
• \(r\) is the discount rate that reflects the riskiness of the estimated cash flows.

As we get into more detail, we will realize that \(r\) includes the risk-free rate of interest, expected inflation, and several risk premiums.

Discount Rate

The discount rate used to compute the expected value of future cash flows is the sum of a real default-free interest rate, several risk premiums, and the expected inflation. It is important to note that the business cycle influences all these elements, thus ultimately influencing the market value.

The discount rate is a reflection of the uncertainty about future cash flows. The elements mentioned above are discussed in more detail here:

• Real default-free fixed-income assets: The first component represents the return that an investor demands on real default-free fixed-income assets today for a cash flow expected in the future.
• Nominal default-free investment: This element of the discount rate compensates for investors’ demand for the inflation expected over the investment horizon. This is due to investors’ concern about the real purchasing power of their investments in the future.
• Risk premium: Due to some uncertainties associated with an asset’s future cash flows, investors expect an additional return. An asset’s risk premium is a reward to investors who bear additional risk, relative to that of a risk-free asset in a portfolio. The size of the risk premium varies across asset classes. The distinction between different asset classes can be attributed to this variation in risk premiums.

Question

An asset’s market value is determined by computing the present value of its expected cash flows at a discount rate that reflects the riskiness of those cash flows. Assuming that all other variables are constant except for the variable discussed below, which of the following statements is most likely accurate?

1. Inflation increases the value of an asset because it increases the expected cash flows.
2. The value of an asset increases with an increase in the discount rate.
3. The value of an asset increases with an increase in the expected growth rate of cash flows.

Solution

The correct answer is C.

The value of an asset is an increasing function of the expected future cash flows.

A is incorrect. Inflation increases the discount rate, which decreases the value of an asset.

B is incorrect. As the discount rate increases, the value of the asset decreases.

Reading 43: Economics and Investment Markets

LOS 43 (a) Explain the notion that to affect market values, economic factors must affect one or more of the following: 1) default-free interest rates across maturities, 2) the timing and magnitude of expected cash flows, and 3) risk premiums.