CFA Level 1: Perpetuity Valuation

Perpetuity Valuation

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Question

Which of the following securities is commonly valued as a perpetuity? Further, which of the following best describes the equation used to value this security?

Answers

A. Zero coupon bond; {P0 = [Face value / (1 + k)^n]}

B. More than one of these answers is correct

C. Preferred stock; {P0 = [d1 / k]}

D. Common stock; {P0 = [d1 / g]}

E. Zero coupon bond; {P0 = [Face value / (1 + k)^n] + g}

F. Preferred stock; {P0 = [(d1 / k) +g]}

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Explanations

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A. B. C. D. E. F.

A "perpetuity" is an investment which is expected to last forever. Preferred stock is commonly valued as a perpetuity, using this equation:

{P0 = [d1 / k]}

Where: , P0 = the price of the preferred stock at time 0, d1 = the dividend at t = 1 and k = the required rate of return.

A zero coupon bond is not an example of a perpetuity, because the duration of the cash flows produced by a zero coupon bond has a finite and measurable life.

Common stock, on the other hand, is sometimes valued as a perpetuity, but the equation provided in this example is incorrect.

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