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.
2. The valuation of a financial asset is equal to the present value of future cash flows.
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.
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
5. The real rate of return is the financial ...view middle of the document...
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. 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.
11. The no-growth pattern for common stock is similar to the dividend on preferred stock.
12. To go from Formula (10-7) to Formula (10-8):
The firm must have a constant growth rate (g).
The discount rate (ke) must exceed the growth rate (g).
13. The two components that make up the required return on common stock are:
b. The growth rate (g). This actually represents the anticipated growth in dividends, earnings, and stock price over the long term.
14. The price-earnings ratio is influenced by the earnings and sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend policy, the quality of management, and a number of other factors. Firms that have bright expectations for the future tend to trade at high P/E ratios while the opposite is true of low P/E firms.
15. The higher the firm’s Ke, the lower will be the price-earnings ratio, assuming all other things remain equal. This makes sense because a relatively high Ke implies a higher level of risk. The greater the estimate of dividend growth (g), the higher the price-earnings ratio because of buoyancy of future expectations.
16. A supernormal growth pattern is represented by very rapid growth in the early years of a company or industry that eventually levels off to more normal growth. The supernormal growth pattern is often experienced by firms in emerging industries, such as in the early days of electronics or microcomputers.
17. In valuing a firm with no cash dividend, one approach is to assume that at some point in the future a cash dividend will be paid, perhaps a liquidating dividend. You can then take the present value of future cash dividends.
A second approach is to take the present value of future earnings as well as a future anticipated stock price. The discount rate applied to future earnings is generally higher than the discount rate applied to future dividends.
Internet Resources and Questions
www.globeandmail.com/business (go to print edition, then bond story)
1. Burns Fire and Casualty Company
a. 6 percent yield to maturity
Present value of interest payments
PVA = A ( PVIFA (n = 20, %i = 6) (Appendix D)
PVA = 110 ( 11.470 = $1,261.70
Present value of principal payment at maturity
PV = FV ( PVIF (n = 20, %i = 6) (Appendix B)
PV = $1,000 ( 0.312 = $312
Total present value: