Rates of Return

1. The valuation of a financial asset is based on the concept of determining the present value of future cash flows.
2. The prices of financial assets are based on the expected value of future cash flows, discount rate, and past dividends.
3. The market determined required rate of return is also called the discount rate.
4. The discount rate depends on the market's perceived level of risk associated with an individual security.
5. By using different discount rates, the market allocates capital to companies based on their risk, efficiency, and
expected returns.
6. In estimating the market value of a bond, the coupon rate should be used as the discount rate.
7. Most bonds promise both a periodic return and a lump-sum payment.
8. A 20-year bond pays 12% annual interest in semi-annual payments. The current market yield to maturity is 10%. The
appropriate interest factors should be in the tables under 5% for 40 periods.
9. The price of a bond is equal to the present value of all future interest payments added to the present value of the
principal.
10. When the interest rate on a bond and its yield to maturity are equal, the bond will trade at par value.
11. An increase in yield to maturity would be associated with an increase in the price of a bond.
12. You hold a long-term bond yielding ten percent. If interest rates fall shortly before you sell the bond, you will sell at a
higher price than if interest rates had been constant.
13. When a bond trades at a discount to par, the yield to maturity on the bond will exceed the required return.
14. The yield to maturity is always equal to the interest payment of a bond.
15. The appropriate discount rate for bonds is called the yield to maturity.
16. The total required real rate of return is equal to the real rate of return plus the inflation premium.
17. Historically the real rate of return has been 2 to 3%.
18. The required rate of return is payment demanded by the investor for foregoing present consumption.
19. The inflation premium is based on past and current inflation levels.
20. The risk-free rate of return is equal to the inflation premium plus the real rate of return.
21. The risk premium is equal to the required yield to maturity minus both the real rate of return and the inflation
premium.
22. The risk premium is primarily concerned with business risk, financial risk, and inflation risk.
23. Business risk relates to the inability of the firm to meet its debt obligations as they come due.
24. Risk premiums are higher for riskier securities, but the risk premium cannot be higher than the required return.
25. High-risk corporate bonds are as risky as junk bonds.
26. There is a negative correlation between risk and the return the investors demand.
27. When inflation rises, bond prices fall.
28. An increase in inflation will cause a bond's required return to rise.
29. The higher the yield to maturity on a bond, the closer to par the bond will trade.
30. The longer the maturity of a bond, the greater the impact on price to changes in market interest rates.
31. As time to maturity increases, bond price sensitivity decreases.
32. The further the yield to maturity of a bond moves away from the bond's coupon rate the greater the price-change
effect will be.
33. The price of preferred stock is determined by dividing the fixed dividend payment by the required rate of return.
34. Preferred stock is compensated for not having ownership privileges by offering a fixed dividend stream supported by
a binding contractual obligation.
35. Preferred stock would be valued the same as a common stock with a zero-dividend growth rate.
36. When inflation rises, preferred stock prices fall.
37. The variable growth model is useful for firms in emerging industries.
38. The value of a share of stock is the present value of the expected stream of future dividends.
39. Valuation of a common stock with no dividend growth potential is treated in the same manner as preferred stock.
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40. The constant dividend growth valuation formula is P = .
(r+g)
41. The variable growth dividend model can be used for both constant and variable growth stocks.
42. To use a dividend valuation model, a firm must have a constant growth rate and the discount rate must not exceed
the growth rate.
43. The drawback of the future stock value procedure is that it does not consider dividend income.
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44. Future stock value is equal to P = , assuming constant growth in dividends.
(r+g)
45. Firms with an expectation for great potential tend to trade at low P/E ratios.
46. The price-earnings ratio is another tool used to measure the value of common stock.
47. Firm's with bright expectations for the future, tend to trade at high P/E ratios.
48. A stock that has a high required rate of return because of its risky nature will usually have a high P/E ratio.
49. The fact that small businesses are usually illiquid does not affect their valuation process.