Deck 4: Applying the Time Value of Money to Security Valuation

Question 1

Given that dividends on a share are expected to remain indefinitely at $1 p.a.and that the required rate of return for the level of risk on such a share is 15%,the correct price for this share:

A)cannot be ascertained from this information.
B)cannot be ascertained without regard to the management structure of the firm.
C)is $1.
D)is $6.67.

Answer 1

is $6.67.

Question 2

At what interest rate would investing $1000 in a bank leave you as well off as receiving $1078 in 12 months' time?

A)5%
B)78%
C)10%
D)7.8%

Answer 2

7.8%

Question 3

The periodic cash flows from an investment in shares are called:

A)coupons.
B)interest.
C)capital gains.
D)dividends.

Answer 3

dividends.

Question 4

If an investor is prepared to pay $600 for an asset that returns $700 at the end of two years,what annual rate of return is the investor receiving?

A)16.7%
B)$100
C)8%
D)8.3%

Question 5

A decision to buy an asset implies a simultaneous decision to forego:

A)future consumption.
B)less consumption.
C)current consumption.
D)none of the given options.

Question 6

A flat term structure implies that investors expect future short-term interest rates to:

A)decrease.
B)increase.
C)be the same as the current rate.
D)none of the options given.

Question 7

A Ltd pays a dividend of 90 cents per share.If A Ltd retains 40% of its earnings each year and these are reinvested to earn a 25% return,what is the price of A Ltd?

A)$1.22
B)$4.40
C)$19.80
D)More information is needed.

Question 8

The price effect and the reinvestment effect are both sources of:

A)default risk.
B)term structure.
C)interest rate risk.
D)default risk structure.

Question 9

If you were able to earn 10% p.a.interest on money invested in a bank,how much money would you be willing to receive in 12 months' time,rather than $1000 now,so that you are indifferent between the two options?

A)$1500
B)$909
C)$900
D)$1100

Question 10

If you have $1000 to invest and are able to earn 8% p.a.interest on money invested in a bank,how much will you be willing to receive in two years' time to be indifferent between the two options?

A)$840
B)$1160
C)$1166
D)$1500

Question 11

Given that dividends on a share are expected to remain indefinitely at $0.50 p.a.and that the required rate of return for the level of risk on such a share is 10% and the interest rate is 6%,the correct price for this share is:

A)$8.33.
B)$5.
C)$3.
D)none of the options given.

Question 12

Assume that for the past 10 years the growth rate in A Ltd's dividends per share has been 10% p.a.Also assume that this growth rate is to be maintained indefinitely.The latest dividend of 90 cents was paid yesterday.What is the value of A's shares?

A)$18.00
B)$6.60
C)$19.80
D)$3.96

Question 13

In general,an upward-sloping term structure implies that investors expect future short-term interest rates to:

A)decrease.
B)increase.
C)be the same as the current rate.
D)increase by a minimum of 5bp.

Question 14

A Ltd is currently paying a dividend of 90 cents per share.Assume that the investors expect this dividend to be maintained indefinitely and that they require a return of 15% on the investment.What is the value of A's shares?

A)$0.14
B)$16.66
C)$6.00
D)$1.05

Question 15

Moody's and Standard and Poor's provide ratings of short-term debt on a:

A)three-point scale.
B)five-point scale.
C)19-point scale.
D)four-point scale.

Question 16

In general,a downward-sloping term structure implies that investors expect future short-term interest rates to:

A)decrease.
B)increase.
C)be the same as the current rate.
D)none of the options given.

Question 17

When valuing shares under uncertainty,the price can be written as:

A)
B)
C)
D)

Question 18

You have a choice between receiving $500 now and $530 in six months' time.Current interest rates are 10% p.a.(simple interest).As a rational investor,which option would you choose and why?

A)$500 now,because receiving $530 in six months' time is equivalent to earning only 6% interest,whereas in the bank you can earn 10% interest.
B)$530 in six months' time,because $500 invested for six months is only worth $525.
C)$500 now,because it would be worth $550 in six months' time.
D)$500 now,because you have the option to invest or consume goods.

Question 19

The appropriate value of K_e is determined using the concept of:

A)risk and return models.
B)internal rate of return.
C)cost of capital.
D)opportunity cost of capital.

Question 20

The connection between term and interest rates is called:

A)interest rate risk.
B)price risk.
C)term structure of interest rates.
D)default structure of interest rates.

Question 21

Assume that XYZ Ltd has a current growth rate of 10% p.a.that is expected to be maintained for only another three years and then fall to 5% p.a. ,where it is expected to remain indefinitely.Given that the required return on ABC's shares is 12% and that the last dividend of 50 cents has just been paid,the price of ABC's shares will be:

A)$8.56.
B)$11.43.
C)$10.25.
D)$9.82.

Question 22

Assume the latest dividend per share,paid recently,for ACD Ltd is 90 cents and that the required rate of return on these shares is 15% p.a.If the current share price is $19.80,the expected growth rate on these shares is:

A)0%.
B)10%.
C)5%.
D)7.5%.

Question 23

The 'price effect',with regards to bonds,refers to the:

A)capital gains or losses that occur when interest rates change.
B)relationship between market interest rates and bond prices.
C)present value of interest income and redemption value.
D)relationship between risk and bond prices.

Question 24

Company A and Company B have identical expected earnings potential but Company B has a higher price-earnings ratio.This discrepancy:

A)can be explained by the difference in share price.
B)can be explained by the fact that Company A pays more dividends.
C)can be explained by the fact that Company A is considered to be riskier than Company
D)cannot be explained.

Question 25

Calculate the expected capital gain on a share that costs $1 and pays a 7c dividend if the share is sold in two years' time.Assume that the required rate of return for such a share is 7% p.a.

A)Loss of 12.7c.
B)Gain of 14c.
C)None of the given options.
D)Gain of 14.49c.

Question 26

There is a natural tendency for the yield on long-term bonds to be greater than on short-term bonds because:

A)holders of long-term bonds benefit most from a fall in interest rates.
B)reinvestment risk is more pronounced for long-term bonds than short-term bonds.
C)long-term bonds are more price-sensitive than short-term bonds.
D)the risk of default is greater for long-term bonds.

Question 27

How much would you be prepared to pay for a share in two years' time that pays a 15c dividend each year and is currently priced at $2? Assume the required rate of return is 7.5% p.a.

A)$1.87
B)$2.30
C)$1.70
D)$2

Question 28

Interest rate risk refers to:

A)the risk-free rate of interest.
B)the risk premium demanded on a bond in case of default.
C)the random behaviour of past bond prices.
D)the unforeseen losses to an investor if interest rates change.

Question 29

The return on a share listed on the stock exchange is likely to be:

A)less than the short-term rate of interest but greater than the long-term rate of interest.
B)more than the short-term rate of interest but less than the long-term rate of interest.
C)greater than the market rate of interest.
D)comparable to the rate of return earned on government securities.

Question 30

What is the market value of a bond that has a required rate of return of 10% p.a.and pays $50 p.a.with only two years remaining to maturity,if the redemption value is $1000 and the initial market value of the bond was $850 when it was first issued eight years ago?

A)$571.80
B)$1421.80
C)$826.45
D)$913.22

Question 31

You have just purchased a government bond for $1100 that promises to pay $100 p.a.over the next five years.The market price of the bond has just increased to $1200.A likely reason for this is:

A)the face value of the bond has been increased.
B)the bond is perceived by the market to be more risky now than before.
C)interest rates,in general,have increased.
D)interest rates,in general,have decreased.

Question 32

What is the required rate of return on a share that pays a $1 dividend each year and is currently valued at $16.66?

A)6%
B)16.66%
C)6.66%
D)none of the options given.

Question 33

An upward-sloping yield curve can best be explained by:

A)the relationship between nominal interest rates and expected inflation rates.
B)the expectation that short-term interest rates will decrease in the future.
C)the fact that short-term interest rates are more inflation-sensitive than long-term rates.
D)the expectation that inflation will increase in the future.

Question 34

The latest dividend paid by ABC Ltd is 40 cents and the company retains 20 per cent of its earnings each year,which is invested to earn a rate of return of 25% p.a.Assuming the required rate of return on ABC's shares is 15% p.a. ,the price of ABC Ltd shares will be:

A)$3.33.
B)$5.
C)$4.
D)$4.20.

Question 35

The expectations theory of the term structure of interest implies that:

A)interest received on securities is in accordance with term to maturity.
B)bond investors can expect to achieve the same return over any future period,regardless of the security in which they invest.
C)there is a premium due to uncertainty about the future level of interest rates.
D)there is a risk that borrowers may default on the payment of the principal.

Question 36

Consider a 10-year bond with a face value of $1000 and with an annual coupon of $100.What is its market value if the appropriate required rate of return is 6% p.a.?

A)$2000
B)$1294.40
C)$1349.51
D)$1752.12

Question 37

Which of the following statements best describes the concept used to value shares?

A)The value of an infinite stream of dividends discounted by the current short-term interest rate assuming a company has an infinite life.
B)Market price can be expressed as the present value of an infinite stream of dividends.
C)The present value of the dividend stream and expected capital gain must be calculated separately and then added together.
D)Market price can be expressed as the present value of an infinite stream of dividends assuming a company has an infinite life.

Question 38

The difference between the opportunity cost of capital for a risky security and a risk-free security is referred to as the:

A)required rate of return.
B)term structure.
C)liquidity premium.
D)risk premium.

Question 39

Liquidity premium theory suggests that:

A)there is a downward bias in the yield curve.
B)the market for some securities may be thinly traded;hence,investors require a reward for this risk.
C)there is an upward bias in the yield curve because interest rate risk decreases with term to maturity.
D)there is a premium due to uncertainty about the future level of interest rates.

Question 40

Risk of default implies that:

A)there is an upward-sloping yield curve.
B)there is a downward-sloping yield curve.
C)AAA-rated bonds are more heavily discounted than BBB-rated bonds.
D)AAA-rated bonds are less heavily discounted than BBB-rated bonds.

Question 41

The yield to maturity on a 1-year bond purchased for $980 with a maturity value of $1100 is:

A)10.05%
B)12.24%
C)13.50%
D)14.23%

Question 42

Immunisation can best be described as:

A)the ability of investors to choose a bond investment that minimises reinvestment risk.
B)the ability of investors to choose a bond investment that minimises interest rate risk.
C)the ability of investors to choose a bond investment that matches cash inflows with outflows.
D)the ability of investors to choose a bond investment that achieves some future target regardless of changes to interest rates.

Question 43

According to the expectations theory of the term structure of interest,if the 1-year bond rate today is 6% p.a.and the 2-year bond rate today is 7% p.a. ,what is the 1-year bond rate next year?

A)6%
B)6.75%
C)7.5%
D)8%

Question 44

Financial assets such as bonds and shares can be valued by discounting their future cash flows and summing these present values.

Question 45

According to the expectations theory of the term structure of interest,if the 1-year bond rate today is 6% p.a.and the 3-year bond rate today is 7.5% p.a. ,what is the 2-year bond rate next year?

A)7.25%
B)7.75%
C)8.25%
D)8.75%

Question 46

The promised yield on a non-interest-bearing security with one year to maturity,a face value of $100,a 20% chance of default and an expected market rate of return of 10%,is:

A)7.8%.
B)37.5%.
C)25%.
D)10%.

Question 47

According to the expectations theory of the term structure of interest,if the 1-year bond rate today is 7% p.a.and the 1-year bond rate in one year's time is 9% p.a. ,what is 2-year bond rate today?

A)6%
B)7.5%
C)8%
D)10%

Question 48

When interest rates increase,interest receipts can be rolled over into a new investment with a higher interest rate.This is known as the _____________ effect.

Question 49

Interest rate elasticity refers to:

A)the response in interest rates to a change in monetary policy.
B)the response in bond price to a change in interest rates.
C)bonds that pay flexible interest rates.
D)the response in interest rates to a change in bond price.

Question 50

One reason that the required rate of return on shares is generally more than on interest-yielding securities is because:

A)borrowers may default on payments.
B)the returns on shares are higher than on interest-yielding securities.
C)debtholders rank ahead of shareholders in case of default.
D)shareholders rank ahead of debtholders in case of default.

Question 51

The price effect and reinvestment effect are both sources of interest rate risk.

Question 52

Which statement regarding bond prices is false?

A)If interest rates rise,bond prices will fall.
B)All bond prices respond to changes in interest rates in the opposite direction,but they do not all respond to the same extent.
C)Bond prices and interest rates are negatively correlated.
D)If bond prices rise,interest rates will fall.

Question 53

The higher the market's assessment of the probability of default,the ___________ the required rate of return on the debt.

Question 54

The ________________ of interest rates is the relationship between the interest rates and time to maturity.

Question 55

Once a bond has been issued,its promised future cash flows are ___________.

Question 56

Downward-sloping yield curves are inconsistent with the liquidity premium theory.

Question 57

The best security to achieve immunisation is:

A)a zero-coupon bond.
B)a low-coupon bond with maturity that matches an investor's target maturity.
C)a zero-coupon bond with maturity that matches an investor's target maturity.
D)a high-coupon bond with maturity that matches an investor's target maturity.

Question 58

Two common methods of share valuation are dividend growth models and the _________________ ratio.

Question 59

A company just paid a dividend of $1.20.If this is expected to increase by 3% p.a.indefinitely,and the required rate of return is 8%,then the theoretical share price is $15.

Question 60

An increase in interest rates results in a _________ in the price of a bond.

Question 61

All other things being equal,an investor will buy a security of high marketability only if the yield is greater than that on a security of low marketability.

Question 62

As debtholders rank ahead of shareholders it is expected that the required rate of return on debt will be less than the required rate of return on shares.