Topic 3 FINC 2011 Tutorial Solutions

Topic 3 FINC 2011 Tutorial Solutions - FINC 2011 Corporate...

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FINC 2011 Corporate Finance 1 Tutorial Questions and Solutions Topic 3 – Valuation of Stocks and Bonds DQ 3 Compare and contrast the basic components of a firm’s capital structure – debt and   equity.  Why is the required rate of return on a firm’s equity capital typically higher  than that for the firm’s debt?  A N S W E R See Table 3.1 for a comparison of features of debt and equity. Differences between debt and equity derive from the nature of the cash flows, the life of the security and the rights to claim against the assets of the company in the case of liquidation. The required rate of return on equity is typically higher than that on debt as a direct consequence of these different features; in particular, the fact that equity ranks behind debt in terms of income payments and return of principal, and because returns to equity holders are much more variable than returns to debtholders. These differences constitute additional risk from the point of view of the investor, and hence a higher rate of return will be required to induce investors to invest in equity securities. DQ 8 What would be the effect on the price of bonds of (1) an unexpected rise in interest   rates, and (2) an unexpected fall in interest rates?  Would these interest rate changes  have a similar effect on the price of shares?  Explain. A N S W E R (1) An unexpected rise in interest rates would have a negative effect on the price of bonds (i.e. it will reduce the market price) due to the inverse relationship between interest rates and bond prices. This is best demonstrated by way of example. Consider the impact of an increase in interest rates to 10% p.a. on a bond with a coupon rate of 8% p.a. If a new bond of similar risk profile were issued with coupon set at the new market interest rate of 10%, then investors would not be willing to pay the same price for the first bond, as its future cash flows (based on coupon multiplied by face value) will be lower. These future cash flows will be discounted at the new market interest rate, so they will have a lower present value, which translates to a lower market price of the bond.
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(2) An unexpected fall in interest rates will have the opposite effect for analogous reasons. Changes in interest rates would have a similar effect on the price
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Topic 3 FINC 2011 Tutorial Solutions - FINC 2011 Corporate...

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