Part 3 Ch 05

Part 3 Ch 05 - CHAPTER 5 ANSWERS 5-1 The value of any asset...

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ANSWERS 5-1 The value of any asset is determined by computing the present value of the future cash flows the asset is expected to generate. 5-2 True. The value of a share of stock is the PV of all its expected future dividends. If the two investors expect the same future dividend stream and they agree on the stock’s riskiness, then they should reach similar conclusions as to the stock’s value regardless of their investment horizons. 5-3 A perpetual bond is similar to a no-growth stock and to a share of preferred stock in the following ways: (1) All three derive their values from a series of cash inflows—that is, coupon payments from the perpetual bond and dividends from both types of stock. (2) All three are assumed to have indefinite lives with no maturity value (M) for the perpetual bond and no capital gains yield for the stocks. 5-4 If interest rates increase after a bond has been issued, the market value of the bond will decrease. Investors can earn the higher yields on alternative investments with similar risk, and thus they will only buy previously issued bonds if their prices have declined to the point where the yields to maturity on the outstanding bonds are equal to the yields on similar risk alternative investments. Everything else equal, the market prices of bonds with longer terms to maturity will change more than the prices of bonds with shorter terms to maturity. 5-5 If interest rates decline significantly, the values of callable bonds will not rise by as much as bonds without call provisions. It is likely that the callable bonds will be called in prior to maturity so that the issuer can take advantage of the new, lower rates. 5-6 Yes. If a company decides to increase its dividend payout ratio, then the dividend yield component will rise but the expected long-term capital gains yield will decline. If a greater percentage of earnings is paid as dividends, less is available for reinvestment in the firm. 5-7 If investors demand a higher required rate of return for investing in Microsoft’s stock, then, all else equal, the price of the stock would have to drop to provide the higher return. In our valuation model, the value for k s in the denominator would increase, which would cause the result of the computation for the value of the stock to decrease. If Microsoft had to pay a $10 million fine for unfair trade practices, all else equal, the value of the stock should decrease because (a) the expected future cash flows of Microsoft will decrease due to the unexpected cash outflow, and (b) investors might now demand a higher rate of return for investing in Microsoft. 5-8 The general principle behind valuing a real asset is the same as for a financial asset. The principal difference is that it probably is more difficult to estimate values for the needed inputs to the valuation model—that is, future cash flows and the required rate of return. We discuss this concept in detail later in the book. 88
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Part 3 Ch 05 - CHAPTER 5 ANSWERS 5-1 The value of any asset...

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