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Unformatted text preview: Chapter 10 Discussion Questions 10-1. The valuation of financial assets is based on the required rate of return to security holders. This, in turn, becomes the cost of financing (capital) to the corporation. 10-2. The valuation of a financial asset is equal to the present value of future cash flows. 10-3. Because BCE, Inc. has less risk than Air Canada, BCE, Inc. has relatively high returns and a strong market position; the latter firms have had financial difficulties. 10-4. The three factors that influence the demanded rate of return are: a. The real rate of return b. The inflation premium c. The risk premium 10-5. The real rate of return is the financial rent received by investors for giving up use of their funds, above inflation and without a risk premium. 10-6. If inflationary expectations increase, the yield to maturity (required rate of return) will increase. This will mean a lower bond price. 10-7. The longer the time period remaining to maturity, the greater the impact of a difference between the rate the bond is paying and the current yield to maturity (required rate of return). For example, a two percent ($20) differential is not very significant for one year, but very significant for 20 years. In the latter case, it will have a much greater effect on the bond price. 10-8. The valuation models represent the complex real world in a simplified manner. As such they are incomplete. If we can keep the other components of the model constant, then the model will hinge on the investor’s required or expected rate of return. Three components of an investor’s required rate of return have been suggested. If a change in an investor’s required return can be fully captured, the model will work. For practical purposes holding other factors constant and fully capturing changes in investor expectations and psychology proves difficult. 10-9. The three adjustments in going from annual to semiannual bond analysis are: 1. Divide the annual interest rate by two. 2. Multiply the number of years by two. 3. Divide the annual yield to maturity by two. 10-10. The longer the life of an investment, the greater the impact of a change in the required rate of return. Since preferred stock has a perpetual life, the impact is likely to be at a maximum. 10-11. The no-growth pattern for common stock is similar to the dividend on preferred stock. Foundations of Fin. Mgt. 6/E Cdn. • Block, Hirt, Short S-251 10-12. To go from Formula (10-7) to Formula (10-8): The firm must have a constant growth rate (g). The discount rate ( k e ) must exceed the growth rate (g). 10-13. The two components that make up the required return on common stock are: a. 1 P D yield Dividend = b. The growth rate (g). This actually represents the anticipated growth in dividends, earnings, and stock price over the long term....
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This note was uploaded on 11/01/2011 for the course BUS Ethics101 taught by Professor Jsmith during the Fall '11 term at Lakehead.
- Fall '11