Deck 10: Valuation and Rates of Return

Question 1

The price of a bond is equal to the present value of all future interest payments added to the present value of the principal.

Answer 1

True

Question 2

Historically, the real rate of return has been about 2% to 3%.

Answer 2

True

Question 3

When the interest rate on a bond and its yield to maturity are equal, the bond will trade at par value.

Answer 3

True

Question 4

When a bond trades at a discount to par, the yield to maturity on the bond will exceed the required return.
In bond valuation, "Yield to Maturity" and "Required Rate of Return" are synonymous, all other things equal.

Question 5

The appropriate discount rate for valuation of bonds is called the yield to maturity.

Question 6

The discount rate depends on the market's perceived level of risk associated with an individual security.

Question 7

The inflation premium is based on past and current inflation levels.

Question 8

A 10-year bond pays 6% annual interest in semi-annual payments. The current market yield to maturity is 4%. The appropriate interest factors should be in the TVM tables under 2% for 20 periods.
i = 4%/2 = 2%, n = 10 × 2 = 20

Question 9

The total required real rate of return is equal to the real rate of return plus the inflation premium.

Question 10

Most bonds promise both a periodic return and a lump-sum payment.

Question 11

In estimating the market value of a bond, the coupon rate should be used as the discount rate.

Question 12

An increase in yield to maturity would be associated with an increase in the price of a bond.
Since the interest rates on a bond are fixed, an increase in yields available on similar bonds means that this bond is less desirable, and would lower its price.

Question 13

You hold a long-term bond yielding 10%. If interest rates fall before you sell the bond, you will sell at a higher price than if interest rates had been constant.
Since the interest rates on a bond are fixed, a decrease in yields available on similar bonds means that this bond is more desirable, and would therefore increase its price.

Question 14

The valuation of a financial asset is based on the concept of determining the present value of future cash flows.

Question 15

The prices of financial assets are based on the expected value of future cash flows, the discount rate, and past dividends.

Question 16

The market-determined required rate of return is the appropriate discount rate used in valuation calculations.

Question 17

The required rate of return is the payment demanded by the investor for foregoing present consumption.

Question 18

By using different discount rates, the market allocates capital to companies based on their risk, efficiency, and expected returns.

Question 19

The yield to maturity is always equal to the interest payment of a bond.

Question 20

The "risk-free rate of return" is equal to the inflation premium plus the real rate of return.

Question 21

Preferred stock is compensated for not having the same ownership privileges as common stock by offering a fixed dividend stream supported by a binding contractual obligation.
Preferred stock DOES have a fixed dividend stream, but does not carry a binding contractual obligation, as does debt.

Question 22

When inflation rises, preferred stock prices fall.

Question 23

The price of preferred stock is determined by dividing the fixed dividend payment by the required rate of return.

Question 24

The value of a share of stock is the present value of the expected stream of future dividends.

Question 25

As time to maturity increases, bond price sensitivity decreases.

Question 26

An increase in inflation will cause a bond's required return to rise.

Question 27

The risk premium is equal to the required yield to maturity (or rate of return) minus both the real rate of return and the inflation premium.

Question 28

The constant dividend growth valuation formula is P₀ = D₁/(K_e - g).

Question 29

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.

Question 30

There is a negative correlation between risk and the return investors demand.
There is a strong positive correlation between risk taken by investors and the return demanded by investors.

Question 31

High-risk corporate bonds are as risky as junk bonds.

Question 32

The longer the maturity of a bond, the greater the impact on price to changes in market interest rates.

Question 33

The variable growth model is most useful for firms in emerging industries.

Question 34

When inflation rises, bond prices fall.

Question 35

Preferred stock would be valued the same as a common stock with a zero dividend growth rate.

Question 36

Valuation of a common stock with no dividend growth potential is treated in the same manner as preferred stock.

Question 37

"Business risk" relates to the inability of the firm to meet its debt obligations as they come due.
Financial risk relates to the inability to meet debt obligations.

Question 38

The "risk premium" is primarily concerned with business risk, financial risk, and inflation risk.
The risk premium includes the business and financial risk elements only.

Question 39

Risk premiums are higher for riskier securities, but the risk premium cannot be higher than the required rate of return.

Question 40

The higher the yield to maturity on a bond, the closer to par the bond will trade.
Increasing the yield to maturity will increase the difference between the par value and the price that buyers are willing to pay for it.

Question 41

A 15-year zero-coupon bond was issued with a $1,000 par value to yield 8%. What is the approximate market value of the bond?

A)$597
B)$315
C)$275
D)$482

Question 42

Which of the following financial assets is likely to have the highest required rate of return based on risk?

A)Corporate bond
B)U.S.Treasury bill
C)Certificate of deposit
D)Common stock

Question 43

The market allocates capital to companies based on

A)risk.
B)efficiency.
C)expected returns.
D)All of these options

Question 44

Which of the following is not one of the components included in the required rate of return on a bond?

A)Risk premium
B)Real rate of return
C)Inflation premium
D)Maturity payment

Question 45

In a general sense, the value of any asset is the

A)value of the dividends received from the asset.
B)present value of the cash flows expected to be received from the asset.
C)value of past dividends and price increases for the asset.
D)future value of the expected earnings discounted by the asset's cost of capital.

Question 46

A stock that has a high required rate of return because of its risky nature will usually have a high P/E ratio.
Per Formula 10-8, a higher K lowers stock price, resulting in a lower P/E ratio.

Question 47

The variable growth dividend model can be used for both constant and variable growth stocks.

Question 48

A bond that has a "yield to maturity" greater than its coupon interest rate will sell for a price

A)below par.
B)at par.
C)above par.
D)that is equal to the face value of the bond plus the value of all interest payments.

Question 49

Even though the IRS tries to minimize occurrences, small business owners often intermingle business and personal expenses in order to minimize taxable income.

Question 50

The price-earnings ratio is another tool used to measure the value of common stock.

Question 51

Future stock value is equal to P₀ = D₁/(K_e - g), assuming a constant growth in dividends.
This formula develops CURRENT stock value, not future.

Question 52

The drawback of the future stock value procedure is that it does not consider dividend income.

Question 53

A 10-year bond, with a par value equaling $1,000, pays 7% annually. If similar bonds are currently yielding 6% annually, what is the market value of the bond? Use semi-annual analysis.

A)$700.00
B)$927.50
C)$1,074.70
D)$1,520.70

Question 54

The fact that small businesses are usually illiquid does not affect their valuation process.

Question 55

Firms with an expectation for great potential tend to trade at low P/E ratios.
Price will be driven up by expectations, yet earnings are not yet realized or strong. The numerator is higher, the denominator lower, resulting in a higher P/E.

Question 56

To use a dividend valuation model, a firm must have a constant growth rate, and the discount rate must not exceed the growth rate.
The growth rate does not necessarily have to be constant, and the discount rate must always exceed the growth rate.

Question 57

Valuation of financial assets requires knowledge of

A)future cash flows.
B)an appropriate discount rate.
C)past asset performance.
D)future cash flows and an appropriate discount rate.

Question 58

A 20-year bond pays 6% on a face value of $1,000. If similar bonds are currently yielding 5%, what is the market value of the bond? Use annual analysis.

A)Over $1,100
B)Under $1,000
C)Under $900
D)Not enough information is given to tell.

Question 59

A 10-year zero-coupon bond that yields 5% is issued with a $1,000 par value. What is the issuance price of the bond? Round to the nearest dollar.

A)$614
B)$64
C)$6,140
D)None of these options

Question 60

Firms with bright expectations for the future tend to trade at high P/E ratios.

Question 61

If the inflation premium for a bond goes up, the price of the bond

A)is unaffected.
B)goes down.
C)goes up.
D)More information is needed for an answer.

Question 62

The dividend valuation model stresses the

A)importance of earnings per share.
B)importance of dividends and legal rules for maximum payment.
C)relationship of dividends to market prices.
D)relationship of dividends to earnings per share.

Question 63

An increase in the riskiness of a particular security would NOT affect

A)the risk premium for that security.
B)the premium for expected inflation.
C)the total required return for the security.
D)investors' willingness to buy the security.

Question 64

A 15-year bond pays 9% on a face value of $1,000. If similar bonds are currently yielding 6%, what is the market value of the bond? Use annual analysis.

A)Over $1,000
B)Under $1,000
C)Over $1,200
D)Not enough information is given to tell.

Question 65

If the yield to maturity on a bond is greater than the coupon rate, you can assume

A)interest rates have decreased.
B)the price is below par.
C)the price is above par.
D)risk premiums have decreased.

Question 66

The return measure that an investor demands for giving up current use of funds, without adjusting for purchasing power changes or the real rate of return, is the

A)risk premium.
B)inflation premium.
C)dividend yield.
D)discount rate.

Question 67

Which is a characteristic of the price of preferred stock?

A)Since preferred stock dividends are fixed, they are tax-deductible.
B)Because preferred stock has no maturity, the price analysis is similar to that of debt.
C)Preferred stock is valued as a perpetuity.
D)None of these options

Question 68

The growth rate for the firm's common stock is 7%. The firm's preferred stock is paying an annual dividend of $3. What is the preferred stock price if the required rate of return is 8%?

A)$3.00
B)$37.50
C)$50.00
D)None of these options

Question 69

An issue of preferred stock is paying an annual dividend of $1.50. The growth rate for the firm's common stock is 5%. What is the preferred stock price if the required rate of return is 7%?

A)$21.43
B)$30.00
C)$22.50
D)None of these options

Question 70

Will an increase in inflation have a larger impact on the price of a bond or preferred stock?

A)The bond.
B)The preferred stock.
C)The impact will be the same.
D)There is not enough information to determine the relative impact.

Question 71

A higher interest rate (discount rate) would

A)reduce the price of corporate bonds.
B)reduce the price of preferred stock.
C)reduce the price of common stock.
D)All of these options

Question 72

A 10-year bond pays 5% on a face value of $1,000. If similar bonds are currently yielding 10%, what is the market value of the bond? Use annual analysis.

A)Less than $900
B)More than $900 and less than $1,100
C)More than $1,100
D)Not enough information is given to tell.

Question 73

The value of a common stock is based on its

A)past performance.
B)historic dividends.
C)current earnings.
D)value of future benefits to the holder.

Question 74

A bond pays 7% yearly interest in semi-annual payments for 10 years. The current yield on similar bonds is 9%. To determine the market value of this bond, you must

A)find the interest factors (IFs) for 20 periods at 9%.
B)find the interest factors (IFs) for 10 periods at 7%.
C)find the interest factors (IFs) for 10 periods at 4.5%.
D)find the interest factors (IFs) for 20 periods at 4.5%.

Question 75

The price of preferred stock may react strongly to a change in K_p because

A)preferred stock may be cumulative.
B)preferred stock dividends have to be paid before common stock dividends.
C)there is no maturity date.
D)corporate recipients of preferred stock dividends may receive a partial tax exemption.

Question 76

The risk premium is likely to be highest for

A)U.S.government bonds.
B)corporate bonds.
C)utility company stock.
D)either corporate bonds or utility company stock.

Question 77

Which of the following does NOT influence the yield to maturity for a security?

A)Required real rate of return
B)Risk free rate
C)Business risk
D)Historic yields

Question 78

Preferred stock has all but which of the following characteristics?

A)No stated maturity.
B)A fixed dividend payment that carries a higher precedence than common stock dividends.
C)The same binding contractual obligation as debt.
D)Preferred lacks the full ownership privilege of common stock.

Question 79

The relationship between a bond's price and the yield to maturity

A)changes at a constant level for each percentage change of yield to maturity.
B)is an inverse relationship.
C)is a linear relationship.
D)changes at a constant level for each percentage change of yield to maturity and is an inverse relationship.

Question 80

The longer the time to maturity,

A)the greater the price increase from an increase in interest rates.
B)the less the price increase from an increase in interest rates.
C)the greater the price increase from a decrease in interest rates.
D)the less the price decrease from a decrease in interest rates.