BUACC5936 Practice/Homework Questions

Answers (Chapter #10)

Mudassir Mehdi
30116545
Answer: 10-2
Three factors that determine the value of an asset:
Asset Characteristics: Characteristics of assets (Securities/Shares/Bonds) comprise of amount of
cash flows expected from them in future, timing of expected cash flows and the level of riskiness
involved with those cash flows.
Investor Attributes: This includes investors assessment of riskiness for cash flows of assets. Also
willingness to bear risk by investor is also essential in these attributes.
Investors Required Rate of Return: An asset can be evaluated if the investor can estimate his
required rate of return. This can be done by calculating the present value of expected cash flows
discounted using the investors required rate of return.
Answer: 10-3
- Basically investors required rate of return derives the value of an asset. It is subjective and
differs as per individual. Required rate of return is the interest rate that a
security needs to offer in order to encourage investors to purchase it. This
is the value of asset in investors perspective therefore required rate of
return provides the bases for valuation of asset.
Answer: 10-4
- Present value of the investments expected future cash flows which are
discounted at investors required rate of return. Intrinsic value is also
termed as fair value and it depicts the level of value (Money) investor is
willingness to forgo in order to buy that asset. It is calculated by using
investors required rate of return.
Answer: 10-5:
a- Par value can also be referred as face value which means that the value of bond at the time of
issuance, on the other hand market value is the price that investor pays in actual for any
particular security. Face/Par value is determined by entity who issues them and it does not
change over the time while the market value changes as per the market condition and
variations in several market factors.
b- Coupon rate or coupon amount is actually that fixed interest which is paid by the issuer to
bondholder annually or on the time period pre-decided at issuance. It is not the percentage in
fact it is dollar amount which is percentage of face value of bond. It is independent of change
in price of bond over the period of time and remains even over number of periods. The
required rate of return on a bond is the interest rate that a bond issuer must offer in order to
get investors interested. Required returns are mostly set by market factors, and are determined
by the price at which issuers and investors agree. Bond Holders required rate of return is
actually is the base of investment decision making in particular instrument for investors.

Answer: 10-6:
Two types of Returns that holders of Ordinary share earn are:
1- Capital Gain (Growth) g - capital appreciation (gain or growth)
means the increase or growth in the value of share over the time
period. g is referred to as the percentage of annual growth in the
shares value.
2- Dividend Income D Dividend is basically amount of money paid on
regular intervals (mainly annually) by a firm to its shareholders. Amount of
dividend is independent of the changes in share values and prices.
Answer: 10-7:
There are several methods to calculate investors required of return for
several types of investment instruments.
For Bonds:
- CAPM Model is a commonly used method investors use to find out their
required rate of return to make investment decisions. Formula for CAPM
Model:
Rj = Rf + j (Rm Rf)
Where:
Rj = The Investors required rate of return on security
RF = the risk-free rate of interest
j = The Bets of Security, value of Beta is different for different securities
depending on several market factors and this Beta is the basis of CAPM
Model.
(Rm RF) = The return on the market index
Rm = Market Risk Premium
-

To calculate investors required rate of return, we need to be

aware of the current value of bond. Then that value can be used
with coupon amount and n number of periods in order to find out
the rate. Hit and Trial Method can be applied to get this rate.
Formula:
Vb (Value) = c [{1-(1+Ir) -n}/Ir}]/Ir + Face Value/ {1+Ir) n
Now we put value of bond and all other amounts, we would need
to use Hit and Trial Method in order to find out required rate of
return for investor.

Answer: 10-8:
INVESTORS EXPECTED RATE OF RETURN: Discount rate which is
equal to the present value of the future cash flows with the current market
price. It can also be described as the rate of return investors are likely to
earn on the maturity of security (Yield to Maturity).