2ND EXAM – FINANCIAL MANAGEMENT
2.2 Real Risk-Free Rate (r*). It is pronounced as “r-star”, and it is the
ELEMENTS OF INTEREST RATES
1. Production Opportunities. The investment opportunities in
productive assets.
2. Time Preferences for Consumption. The preferences of
consumers for current consumption as opposed to saving for future
consumption.
3. Risk. In a financial market context, the chance that an investment
will provide a low or negative return.
4. Inflation. The amount by which prices increase over time.
5. Nominal (Quoted) Risk-Free Rate, rRF. The rate of interest on a
security that is free of all risk. (r* + IP)
6. Inflation Premium (IP). A premium equal to expected inflation
that investors add to the real risk-free rate of return.
7. Default Risk Premium (DRP). The difference between the interest
rate on a Treasury Bond and a Corporate Bond of equal maturity and
marketability.
8. Liquidity Premium (LP). A premium added to the equilibrium
interest rate on a security if that security cannot be converted to
cash on short notice and at close to its fair market value.
9. Interest Rate Risk. The risk of capital losses to which investors are
exposed because of changing interest rates.
10. Maturity Risk Premium (MRP). A premium that reflects interest
rate risk.
11. Reinvestment Rate Risk. The risk that a decline in interest rates
will lead to lower income when bonds mature and funds are
reinvested.
12. Yield Curve. A graph showing the relationship between bond
yields and maturities.
13. Normal Yield Curve. An upward-sloping yield curve.
14. Inverted Yield Curve. A downward-sloping yield curve.
15. Pure Expectations Theory. A theory that states that the shape of
the yield curve depends on investors’ expectations about future
interest rates.
16. Foreign Trade Deficit. The situation that exists when a country
imports more than it exports.
Companies raise capital in two main forms: debt and equity. As a
future finance professional, students should understand interest
rates and its determinants.
1. FACTORS THAT AFFECT LEVELS OF INTEREST RATES. These are the
four most fundamental factors affecting the cost of money:
1.1. Production Opportunities. These are investment opportunities
in productive (cash-generating) assets.
1.2. Time Preferences for consumption. The preferences of
consumers for current consumption as opposed to saving for future
consumption.
1.3. Risk. In a financial market context, the chance that an
investment will provide a low or negative return.
1.4. Inflation. The amount by which prices increase over time.
2. DETERMINANTS OF INTEREST RATES. In general, the quoted (or
nominal) interest rate on a debt security, r, is composed of a real
risk-free rate of interest, r*, plus several premiums that reflect
inflation, the security’s risk, and its marketability (or liquidity). This
relationship can be expressed as follows:
2.1 Quoted or Nominal Rate (r). This is the required return on a debt
security.
rate that would exist on a riskless security in a world with no
inflation. The real risk-free rate is not static since it changes over
time depending on economic conditions like the corporate rate of
return and other borrowers’ expectations on productive assets, and
on people’s time preferences for current versus future consumption.
The best estimate of r* is the rate of return on indexed Treasury
bonds.
2.3 Risk-Free Rate (rRF). It is the quoted rate on a risk-free security
such as government bills, which are mostly very liquid and free of
most types of risk. It is the real risk-free rate added with inflation
premium (r* + IP).
2.4 Inflation Premium (IP). It is equal to the average expected
inflation rate over the life of the security. The expected future
inflation rate is not necessarily equal to the current inflation rate. It
has a major impact on interest rates since it erodes the purchasing
power and lowers real investment returns.
2.5 Default Risk Premium (DRP). The risk that a borrower will
default, which means not making scheduled interest or principal
payments. It has a direct relationship with interest rates. The greater
the risk of default, the higher the interest rate. Treasury securities
have no default risk.
2.6 Liquidity Premium (LP). A premium added to the equilibrium
interest rate on a security if that security cannot be converted to
cash on short notice and at close to its fair market value. Generally,
real assets are less liquid than financial assets.
2.7 Maturity Risk Premium (MRP). It is the premium that reflects
interest rate risk. It varies somewhat over time, rising when interest
rates are more volatile and uncertain, then falling when interest
rates are more stable. The effect of maturity risk premiums is to
raise interest rates on long-term bonds relative to those on short-
term bonds.
• Interest Rate Risk. The risk of capital losses to which investors are
exposed because of changing interest rates. The more interest rate
risk, the longer the maturity of the security.
• Reinvestment Rate Risk. The risk that a decline in interest rates
will lead to lower income when bonds mature and funds are
reinvested. Short-term securities are heavily exposed to
reinvestment rate risk.
3. PREMIUMS ADDED TO R* FOR DIFFERENT TYPES OF DEBT.
4. THE TERM STRUCTURE OF INTEREST RATES. It describes the
relationship between long and short-term rates. The term structure
is important both to corporate treasurers deciding whether to
borrow by issuing long- or short-term debt and to investors who are
deciding whether to buy long- or short-term bonds. Therefore, both
borrowers and lenders should understand how long and short-term
rates relate to each other and what causes shifts in their relative
levels. 5.2 Step 2: Find the Appropriate Maturity Risk Premium (MRP). For
4.1 Illustration. U.S. Treasury Bond Interest Rates on Different this example, the following equation will be used to find a security’s
Dates: appropriate maturity risk premium.

Please note that since the equation is linear, the maturity risk
premium is increasing as the time to maturity increases. The longer
the maturity, the higher the rates.

5.3 Step 3: Adding the Premiums to r*. This is to get the appropriate
nominal rates.

5.4 Hypothetical Yield Curve. Now, we construct the yield curve

based on the illustration above.

• Normal Yield Curve. It is an upward-sloping curve. In the

illustration above, the rates in February 2005 are considered a
Normal Yield Curve.

• Abnormal Yield Curve. It is sometimes called “Inverted Yield

Curve”. This is a downward-sloping yield curve. In the illustration
above, the rates in March 1980 are considered an Abnormal Yield
Curve.

• Humped Yield Curve. A yield curve where interest rates on

medium-term maturities are higher than rates on both short and
long-term maturities. In the illustration above, the rates in February
2000 are considered a humped yield curve.
6. RELATIONSHIP BETWEEN TREASURY YIELD CURVE AND YIELD
CURVES FOR CORPORATE ISSUES. Corporate Yield Curves are higher
5. CONSTRUCTING THE YIELD CURVE
than that of Treasury securities due to the presence of Default Risk
and Liquidity Premiums.
5.1 Step 1: Find the Average Expected Inflation Rate (IP) Over Years
1 to N.

6.1 Illustration

The firm must earn these IPs to break even vs. inflation since these
IPs would permit you to earn r* before taxes.
Corporate bonds’ default and liquidity risks are affected by their
maturities. Established corporations’ short-term bonds have very
small default risk premium since it has almost no chance to go
bankrupt. However, long-term bonds have a higher probability of
default risk than on its short-term ones. Longer-term corporate
bonds are also less liquid than shorter-term bonds.
7. PURE EXPECTATIONS THEORY. The pure expectations theory
contends that the shape of the yield curve depends on investors’
expectations about future interest rates.
7.1 Assumptions of Pure Expectations.
• Assumes that the maturity risk premium for Treasury securities is
zero.
• Long-term rates are an average of current and future short-term
rates.
• If the pure expectations theory is correct, you can use the yield
curve to “back out” expected future interest rates.
7.2 Illustration
7.3 Conclusions About Pure Expectations. Some would argue that
the MRP is not zero, hence, the pure expectations theory is
incorrect. Most evidence supports the general view that lenders
prefer short-term securities, and view long-term securities are
riskier. Thus, investors demand a premium to persuade them to hold
long-term securities.
8. MACROECONOMIC FACTORS THAT INFLUENCE INTEREST RATE
LEVELS.
8.1 Federal Reserve Policy
8.2 Federal Budget Deficits or Surpluses
8.3 International Factors
8.4 Level of Business Activity
Activity 1. True or False.
1. One of the four most fundamental factors that affect the cost of
money is the current state of the weather. If the weather is dark and
stormy, the cost of money will be higher than if it is bright and
sunny, other things held constant.
2. One of the four most fundamental factors that affect the cost of
money as discussed in the text is the expected rate of inflation. If
inflation is expected to be relatively high, then interest rates will
tend to be relatively low, other things held constant.
3. One of the four most fundamental factors that affect the cost of
money as discussed in the text is the risk inherent in a given security.
The higher the risk, the higher the security's required return, other
things held constant.
4. One of the four most fundamental factors that affect the cost of
money as discussed in the text is the time preference for
consumption. The higher the time preference, the lower the cost of
money, other things held constant.
5. The four most fundamental factors that affect the cost of money
are (1) production opportunities, (2) time preferences for
consumption, (3) risk, and (4) inflation.
6. If the demand curve for funds increased but the supply curve
remained constant, we would expect to see the total amount of
funds supplied and demanded increase and interest rates in general
also increase.
7. During periods when inflation is increasing, interest rates tend to
increase, while interest rates tend to fall when inflation is declining.
8. If investors expect a zero rate of inflation, then the nominal rate
of return on a very short-term U.S. Treasury bond should be equal to
the real risk-free rate, r*.
9. The risk that interest rates will increase, and that increase will
lead to a decline in the prices of outstanding bonds, is called
"interest rate risk," or "price risk."
10. Because the maturity risk premium is normally positive, the yield
curve is normally upward sloping.
Activity 2.
1. Assume that inflation is expected to decline in the future, but
that the real risk-free rate, r*, will remain constant. Which of the
following statements is CORRECT, other things held constant?
a. If the pure expectations theory holds, the Treasury yield curve
must be downward sloping.
b. If the pure expectations theory holds, the corporate yield curve
must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield
curve must be upward sloping.
d. If inflation is expected to decline, there can be no maturity risk
premium.
2. Which of the following factors would be most likely to lead to an
increase in nominal interest rates?
a. Households reduce their consumption and increase their savings.
b. A new technology like the internet has just been introduced, and
it increases investment opportunities.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.
3. Which of the following statements is CORRECT, other things held
constant?
a. If companies have fewer good investment opportunities, interest
rates are likely to increase.
b. If individuals increase their savings rate, interest rates are likely to
increase.
c. If expected inflation increases, interest rates are likely to increase.
d. Interest rates on all debt securities.
4. In the foreseeable future, the real risk-free rate of interest, r*, is
expected to remain at 3%, inflation is expected to steadily
increase, and the maturity risk premium is expected to be 0.1(t − 1)
%, where t is the number of years until the bond matures. Given
this information, which of the following statements is CORRECT?
a. The yield on 2-year Treasury securities must exceed the yield on 5-
year Treasury securities.
b. The yield on 5-year Treasury securities must exceed the yield on
10-year corporate bonds.
c. The yield curve must be humped.
d. The yield curve must be upward sloping.
5. If the Treasury yield curve is downward sloping, how should the
yield to maturity on a 10-year Treasury coupon bond compared to
that on a 1-year T-bill?
a. The yield on a 10-year bond would be less than that on a 1-year
bill.
b. The yield on a 10-year bond would have to be higher than that on
a 1-year bill because of the maturity risk premium.
c. It is impossible to tell without knowing the coupon rates of the
bonds.
d. The yields on the two securities would be equal.
6. Suppose 1-year T-bills currently yield 7.00% and the future
inflation rate is expected to be constant at 3.20% per year. What is
the real risk-free rate of return, r*? Disregard any cross-product
terms, i.e., if averaging is required, use the arithmetic average.
a. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%
7. Suppose the real risk-free rate is 3.50% and the future rate of
inflation is expected to be constant at 2.20%. What rate of return
would you expect on a 1-year Treasury security, assuming the pure
expectations theory is valid? Disregard cross-product terms, i.e., if
averaging is required, use the arithmetic average.
a. 5.14%
b. 5.42%
c. 5.70%
d. 5.99%
8. Suppose the real risk-free rate is 2.50% and the future rate of
inflation is expected to be constant at 4.10%. What rate of return
would you expect on a 5-year Treasury security, assuming the pure
expectations theory is valid? Disregard cross-product terms, i.e., if
averaging is required, use the arithmetic average.
a. 5.38%
b. 5.66%
c. 5.96%
d. 6.60%
9. Suppose the yield on a 10-year T-bond is currently 5.05% and
that on a 10-year Treasury Inflation Protected Security (TIPS) is
2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%,
that no MRP is required on a TIPS, and that no liquidity premium is
required on any T-bond. Given this information, what is the
expected rate of inflation over the next 10 years? Disregard cross-
product terms, i.e., if averaging is required, use the arithmetic
average.
a. 1.81%
b. 1.90%
c. 2.00%
d. 2.10%
10. Suppose 10-year T-bonds have a yield of 5.30% and 10-year
corporate bonds yield 6.75%. Also, corporate bonds have a 0.25%
liquidity premium versus a zero-liquidity premium for T-bonds, and
the maturity risk premium on both Treasury and corporate 10-year
bonds is 1.15%. What is the default risk premium on corporate
bonds?
19. Indexed (Purchasing Power) Bond. A bond that has interest
payments based on an inflation index so as to protect the holder
from inflation.
20. Discount Bond. A bond that sells below its par value. It occurs
whenever the growing rate of interest is above the coupon rate.
21. Premium Bond. A bond that sells above its par value. It occurs
whenever the going rate of interest is below the coupon rate.
22. Yield to Maturity (YTM). The rate of return earned on a bond if it
is held to maturity.
23. Yield to Call (YTC). The rate of return earned on a bond if it is
called before its maturity date.
24. Current Yield. The annual interest payment on a bond is divided
by the bond’s current price.
25. Mortgage Bond. A bond backed by fixed assets.
26. Indenture. A formal agreement between the issuer and the
bondholders.
27. Debenture. A long-term bond that is not secured by a mortgage
on specific property.
28. Investment-Grade Bonds. Bonds rated triple-B or higher.
29. Junk Bond. A high-risk, high-yield bond.

a. 1.08% Companies raise capital in two main forms: debt and equity. As a
b. 1.20% future finance professional, students should understand interest
c. 1.32% rates and its determinants.
d. 1.45%
1. BOND. A long-term debt instrument which a borrower agrees to
make payments of principal and interest, on specific dates, to the
BONDS AND THEIR VALUATION holders of the bond.

1. Bond. A long-term debt instrument in which a borrower agrees to 1.1. Who issues bonds?
make payments of principal and interest, on specific dates, to the
holders of the bond.
2. Treasury Bonds. Bonds issued by the federal government,
sometimes referred to as government bonds.
3. Corporate Bonds. Bonds issued by corporations.
4. Municipal Bonds. Bonds issued by state and local government.
5. Foreign Bonds. Bonds issued by either foreign governments or
foreign corporations.
6. Par Value. The face value of a bond.
7. Coupon Payment. The specified number of pesos of interest paid
each year.
8. Coupon Interest Rate. The stated annual interest rate on a bond.
9. Floating-Rate Bond. A bond whose interest rate fluctuates with
shifts in the general level of interest rates.
10. Zero-Coupon Bond. A bond that pays no annual interest but is
sold at a discount below par, thus providing compensation to
investors in the form of capital appreciation.
11. Original Issue Discount (OID) Bond. Any bond originally offered
at a price below its par value.
12. Maturity Date. A specified date on which the par value of a bond
must be repaid.
13. Call Provision. A provision in a bond contract that gives the
issuer the right to redeem the bonds under specified terms prior to
the normal maturity date.
14. Sinking Fund Provision. A provision in a bond contract requires
the issuer to retire a portion of the bond issue each year. 2. BOND MARKETS. Bonds are primarily traded in the over-the-
15. Convertible Bond. A bond that is exchangeable, at the option of counter market. Most bonds are owned by and traded among large
the holder, for the issuing firm’s common stock. financial institutions.
16. Warrant. A long-term option to buy a stated number of shares of 3. KEY FEATURES OF A BOND.
common stock at a specified price.
17. Putable Bond. A bond with provisions that allow its investors to 3.1. Par Value. It is the face amount of the bond, which is paid at
sell it back to the company prior to maturity at a pre-arranged price. maturity.
18. Income Bond. A bond that pays interest only if it is earned. 3.2. Coupon Interest Rate. This is the stated interest rate (generally
fixed) paid by the issuer. It is multiplied by the par value to get
interest payment. (Int. Pmt. = Par Value x Coupon Interest Rate)
3.3. Maturity Date. This is the years until the bond must be repaid. 4.3. Illustration 2. In relation to the previous illustration, what is the
3.4. Issue Date. The date when the bond was issued. value of a 10-year, P1,000 bond outstanding with the same risk but a
3.5. Yield to Maturity (YTM). This is the rate of return earned on a 13% annual coupon rate?
bond held until maturity. It is also called the promised yield.
3.6. Call Provisions. A provision in a bond contract that gives the
issuer the right to redeem the bonds under specified terms prior to
the normal maturity date. It allows the issuer to refund the bond
issue if rates decline. It helps the issuer but hurts the investor. Bond
investors require higher yields on callable bonds. In many cases,
callable bonds include a deferred call provision and a declining call
premium.
3.7. Sinking Funds. It is a provision to pay off a loan over its life
rather than all at maturity. It reduces the risk to investor and
shortens the average maturity. However, it is not good for investors
if rates decline after issuance.

3.7.1. Calling issues at par for sinking fund purposes. It is likely to be

used if the cost of debt is below the coupon rate and the bond sells
at a premium.

3.7.2. Buying bonds in the open market. Likely to be used if cost of

debt is above the coupon rate and the bond sells at a discount.

4. BOND VALUATION. The value of any financial asset, including

bonds, is simply the present value of the cash flows the asset is
expected to produce.
4.4. Illustration 3. In relation to the previous illustrations, what is
4.1. Opportunity Cost of Debt Capital. The discount rate (ri) is the the value of a 10-year bond outstanding with the same risk but a 7%
opportunity cost of capital and is the rate that could be earned on annual coupon rate?
alternative investments of equal risk.

4.2. Illustration 1. What is the value of a 10-year, P1,000 10% annual

coupon bond, if rd = 10%?

Or

5. CALCULATING THE YIELD TO MATURITY (YTM) OF BONDS. These

are the alternatives for finding the YTM of bonds:
5.1. Illustration 1. Compute the YTM of a 10-year, 9% annual
coupon, P1,000 par value bond that is selling for P887.

5.2. Illustration 2. Compute the YTM of a 10-year, 9% annual

coupon, P1,000 par value bond that is selling for P1,134.20.

8. REINVESTMENT RISK. It is the concern that rd will fall, and future

cash flows will have to be reinvested at lower rates, hence reducing
income.

8.1. Illustration. You have P500,000 and you may invest it in either a
10-year bond or a series of ten 1-year bonds. Both 10-year and 1-
year bonds currently yield 10%.

8.1.1. 1-Year Bond Strategy. After Year 1, you will receive P50,000 in
income and have P500,000 to reinvest. But, if 1-year rates fall to 3%,
your annual income would fall to P15,000.
6. CURRENT YIELD AND CAPITAL GAINS YIELD
8.1.2. 10-Year Bond Strategy. You can lock in a 10% interest rate,
and P50,000 annual income for 10 years, assuming that the bond is
not callable.

9. CONCLUSIONS ABOUT PRICE RISK AND REINVESTMENT RISK.

6.1. Illustration. Find the current yield and the capital gains yield for
a 10-year, 9% annual coupon bond that sells for $887, and has a face
value of $1,000.

10. SEMIANNUAL BONDS.

10.1. Illustration. What is the value of a 10-year, P1,000 par, 10%

semiannual coupon bond, if rd = 13%?
7. PRICE RISK. It is the concern that rising rd will cause the value of a
bond to fall.

7.1. Illustration. Which bond has more price risk, a 1-year or 10-
years P1,000 bond with 10% annual coupon rate?

11. YIELD TO CALL (YTC). The rate of return earned on a bond if it is
called before its maturity date. The computation of YTC is similar
with the formula of YTM, except the time to call is used for N and
the call premium is your Face Value (F).
11.1. Illustration. A 10-year, P1,000 par, 10% semiannual coupon
bond selling for P1,135.90 can be called in 4 years for P1,050. What
is its yield to call (YTC)?
11.2. When is a call more likely to occur? In general, if a bond sells
at a premium, then coupon rate > rd. Thus, a call is more likely. You
should expect to earn YTC on premium bonds and YTM on par and
discount bonds.
Activity 1.
1. If a firm raises capital by selling new bonds, it could be called the
"issuing firm," and the coupon rate is generally set equal to the
required rate on bonds of equal risk.
2. A call provision gives bondholders the right to demand, or "call
for," repayment of a bond. Typically, companies call bonds if interest
rates rise and do not call them if interest rates decline.
3. Sinking funds are provisions included in bond indentures that
require companies to retire bonds on a scheduled basis prior to their
final maturity. Many indentures allow the company to acquire bonds
for sinking fund purposes by either (1) purchasing bonds on the
open market at the going market price or (2) selecting the bonds to
be called by a lottery administered by the trustee, in which case the
price paid is the bond's face value.
4. A zero coupon bond is a bond that pays no interest and is offered
(and initially sells) at par. These bonds provide compensation to
investors in the form of capital appreciation.
5. The market value of any real or financial asset, including stocks,
bonds, or artwork purchased in the hope of selling it at a profit, may
be estimated by determining future cash flows and then discounting
them back to the present.
6. Which of the following statements is CORRECT?
a. You hold two bonds, a 10-year, zero coupon, issue and a 10-year
bond that pays a 6% annual coupon. The same market rate, 6%,
applies to both bonds. If the market rate rises from its current level,
the zero-coupon bond will experience a larger percentage decline.
b. The time to maturity does not affect the change in the value of a
bond in response to a given change in interest rates.
c. You hold two bonds. One is a 10-year, zero coupon, bond and the
other is a 10- year bond that pays a 6% annual coupon. The same
market rate, 6%, applies to both bonds. If the market rate rises from
the current level, the zero-coupon bond will experience a smaller
percentage decline.
d. The shorter the time to maturity, the greater the change in the
value of a bond in response to a given change in interest rates, other
things held constant.
7. Which of the following events would make it more likely that a
company would call its outstanding callable bonds?
a. The company's bonds are downgraded.
b. Market interest rates rise sharply.
c. Market interest rates decline sharply.
d. The company's financial situation deteriorates significantly.
8. Assume that interest rates on 20-year Treasury and corporate
bonds with different ratings, all of which are noncallable, are as
follows:
The differences in rates among these issues were most probably
caused primarily by:
a. Real risk-free rate differences.
b. Tax effects.
c. Default and liquidity risk differences.
d. Maturity risk differences.
9. Under normal conditions, which of the following would be most
likely to increase the coupon rate required for a bond to be issued
at par?
a. Adding additional restrictive covenants that limit management's
actions.
b. Adding a call provision.
c. The rating agencies change the bond's rating from Baa to Aaa.
d. Making the bond a first mortgage bond rather than a debenture.
10. Three $1,000 face value, 10-year, noncallable, bonds have the
same amount of risk, hence their YTMs are equal. Bond 8 has an
8% annual coupon, Bond 10 has a 10% annual coupon, and Bond 12
has a 12% annual coupon. Bond 10 sells at par. Assuming that c. Even if a bond's YTC exceeds its YTM, an investor with an
interest rates remain constant for the next 10 years, which of the investment horizon longer than the bond's maturity would be worse
following statements is CORRECT? off if the bond were called.
d. A bond is likely to be called if its market price is equal to its par
a. Bond 8's current yield will increase each year. value.
b. Since the bonds have the same YTM, they should all have the
same price, and since interest rates are not expected to change, 6. Ringgo Company's bonds mature in 8 years, have a par value of
their prices should all remain at their current levels until maturity. P1,000, and make an annual coupon interest payment of P65. The
c. Bond 12 sells at a premium (its price is greater than par), and its market requires an interest rate of 8.2% on these bonds. What is
price is expected to increase over the next year. the bond's price?
d. Bond 8 sells at a discount (its price is less than par), and its price is
expected to increase over the next year. a. P903.04
b. P925.62
Activity 2. c. P948.76
d. P972.48
1. Assume that all interest rates in the economy decline from 10%
to 9%. Which of the following bonds would have the largest 7. Randy Inc. recently issued noncallable bonds that mature in 15
percentage increase in price? years. They have a par value of P1,000 and an annual coupon of
5.7%. If the current market interest rate is 7.0%, at what price
a. An 8-year bond with a 9% coupon. should the bonds sell?
b. A 1-year bond with a 15% coupon.
c. A 3-year bond with a 10% coupon. a. P817.12
d. A 10-year zero coupon bond. b. P838.07
c. P859.56
2. Which of the following statements is CORRECT? d. P881.60

a. All else equal, high-coupon bonds have less reinvestment risk than
low-coupon bonds.
b. All else equal, long-term bonds have less price risk than short-
term bonds.
8. Greatpenny Corporation issued 20-year, noncallable, 7.5%
annual coupon bonds at their par value of P1,000 one year ago.
Today, the market interest rate on these bonds is 5.5%. What is the
current price of the bonds, given that they now have 19 years to
maturity?

c. All else equal, low-coupon bonds have less price risk than high- a. P1,113.48
coupon bonds. b. P1,171.32
c. P1,201.35
d. All else equal, long-term bonds have less reinvestment risk than d. P1,232.15
short-term bonds.
9. Jolly Inc.'s bonds currently sell for P1,250. They pay a P90 annual
3. A Treasury bond has an 8% annual coupon and a 7.5% yield to coupon, have a 25-year maturity, and a P1,000 par value, but they
maturity. Which of the following statements is CORRECT? can be called in 5 years at P1,050. Assume that no costs other than
the call premium would be incurred to call and refund the bonds,
a. The bond sells at a price below par. and also assume that the yield curve is horizontal, with rates
b. The bond has a current yield greater than 8%. expected to remain at current levels into the future. What is the
c. The bond sells at a discount. difference between this bond's YTM and its YTC? (Subtract the YTC
d. If the yield to maturity remains constant, the price of the bond from the YTM; it is possible to get a negative answer.)
will decline over time.
a. 2.62%
4. Bond X has an 8% annual coupon, Bond Y has a 10% annual b. 2.88%
coupon, and Bond Z has a 12% annual coupon. Each of the bonds is c. 3.17%
noncallable, has a maturity of 10 years, and has a yield to maturity d. 3.48%
of 10%. Which of the following statements is CORRECT?
10. Keanu Industries has a bond outstanding with 15 years to
a. If the bonds' market interest rate remains at 10%, Bond Z's price maturity, an 8.25% nominal coupon, semiannual payments, and a
will be lower one year from now than it is today. P1,000 par value. The bond has a 6.50% nominal yield to maturity,
b. Bond X has the greatest reinvestment risk. but it can be called in 6 years at a price of P1,120. What is the
c. If market interest rates decline, the prices of all three bonds will bond's nominal yield to call?
increase, but Z's price will have the largest percentage increase.
d. If market interest rates remain at 10%, Bond Z's price will be 10% a. 6.20%
higher one year from today. b. 6.53%
c. 6.85%
5. Which of the following statements is CORRECT? d. 7.20%

a. A bond is likely to be called if its coupon rate is below its YTM.

b. A bond is likely to be called if its market price is below its par
value.
RISKS AND RATES OF RETURN

1. Risk. The chance that some unfavorable event will occur.

2. Stand-Alone Risk. The risk an investor would face if he or she held
only one asset.
3. Probability Distribution. A listing of all possible outcomes, or
events, with a probability assigned to each outcome.
4. Expected Rate of Return, r. The rate of return expected to be
realized from an investment, the weighted average of the probability 3. ILLUSTRATION – INVESTMENT ALTERNATIVES.
distribution of possible results.
5. Standard Deviation. A statistical measure of the variability of a set
of observations.
6. Variance. The square of the standard deviation.
7. Coefficient of Variation. Standardized measure of the risk per unit
of return; calculated as the standard deviation divided by the
expected return.
8. Risk Aversion. Risk-averse investors dislike risk and require higher
rates of return as an inducement to buy riskier securities.
9. Risk Premium. The difference between the expected rate of
return on a given risky asset and that on a less risky asset.
10. Expected Return on a Portfolio. The weighted average of the
expected returns on the assets held in the portfolio.
11. Realized Rate of Return. The return that was actually earned
during some past period. The actual return usually turns out to be
different from the expected return except for riskless assets.
12. Correlation. The tendency of two variables to move together. 3.1. T-Bill Returns. They are independent of the economy. T-bills do
13. Correlation Coefficient. A measure of the degree of relationship not provide a completely risk-free return, as they are still exposed to
between two variables. inflation. Although, unexpected inflation is not likely to occur over
14. Market Portfolio. A portfolio consisting of all stocks. such a short period of time. T-bills also have high reinvestment risk.
15. Diversifiable Risk. That part of a security’s risk associated with However, it is free from default risk.
random events; it can be eliminated by proper diversification. 3.2. HT Returns. Moves with the economy and has a positive
16. Market Risk. That part of a security’s risk that cannot be correlation. This is typical.
eliminated by diversification. 3.3. Collections. It has a negative correlation with the economy. This
17. Capital Asset Pricing Model (CAPM). A model based on the is not the usual case.
proposition that any stock’s required rate of return is equal to the 3.4. Calculating for the Expected Return.
risk-free rate of return plus a risk premium that reflects only the risk
remaining after diversification. 3.4.1. HT.
18. Relevant Risk. The risk of security Cannot be diversified away.
This is the risk that affects portfolio risk, and this is relevant to a
rational investor.
19. Beta Coefficient. A metric that shows the extent to which a given
stock’s returns move up and down with the stock market. Beta
measures market risk.
20. Market Risk Premium. The additional return over the risk-free
rate is needed to compensate investors for assuming an average
amount of risk.
21. Security Market Line (SML) Equation. An equation that shows
the relationship between risk as measured by beta and the required
rates of return on individual securities. 3.4.2. Summary of Expected Returns. Follow the formula in HT:

1. INVESTMENT RISK. Related to the probability of earning a low or

negative actual return. The greater the chance of lower than
expected, or negative returns, the riskier the investment.

1.1. Types of Investment Risk.

1.1.1. Stand-alone Risk
1.1.2. Portfolio Risk
2. PROBABILITY DISTRIBUTIONS. A listing of all possible outcomes,
and the probability of each occurrence. It can be shown graphically.
High Tech has the highest expected return and the best investment
alternative based on the computation. However, we must not forget
to take account of its risk.
3.5. Calculating Standard Deviation. It measures the total or stand-
alone risk. The larger the standard deviation is, the lower the
probability that actual returns will be close to expected returns.
 6.2. Diversifiable Risk. A portion of a security’s stand-alone risk can
be eliminated through proper diversification.

7. FAILURE TO DIVERSIFY. The investor will not be compensated for

the extra risk they bear if they don’t diversify.

8. CAPITAL ASSET PRICING MODEL (CAPM). Model linking risk and

required returns. CAPM suggests that there is a Security Market Line
that states that a stock’s required return equals the risk-free return
plus a risk premium that reflects the stock’s risk after diversification.

8.1. Beta. Measures stock’s market risk and shows a stock’s volatility
relative to the market. It indicates how risky a stock is if the stock is
held in a well-diversified portfolio.

8.1.1. Beta = 1.0. Security is just as risky as the average stock.

8.1.2. Beta > 1.0. Security is riskier than average.
8.1.3. Beta < 1.0. Security is less risky than average.

8.2. Illustration.

3.6. Comparing Risk and Return.

8.3. Security Market Line (SML): Calculating Required Rates of
Return

3.7. Coefficient of Variation. A standardized measure of dispersion

about the expected value, that shows the risk per unit of return.

8.4. Market Risk Premium. Additional return over the risk-free rate
needed to compensate investors for assuming an average amount of
risk. Its size depends on the perceived risk of the stock market and
investors’ degree of risk aversion.

Collections have the highest degree of risk per unit of return.

4. RISK AVERSION. Assumes investors dislike risk and require higher

rates of return to encourage them to hold riskier securities.
5. RISK PREMIUM. The difference between the return on a risky
asset and a riskless asset, which serves as compensation for
investors to hold riskier securities.
8.5. Expected Return vs. Required Return
6. SOURCES OF STAND-ALONE RISK.

6.1. Market Risk. A portion of a security’s stand-alone risk cannot be

eliminated through diversification. It is measured by beta.
 c. B;A
d. C;A
e. C;B

2. Which is the best measure of risk for a single asset held in

isolation, and which is the best measure for an asset held in a
diversified portfolio?

a. Variance; correlation coefficient.

Activity 1. True or False.
b. Standard deviation; correlation coefficient.
c. Beta; variance.
1. The tighter the probability distribution of its expected future
d. Coefficient of variation; beta.
returns, the greater the risk of a given investment as measured by its
e. Beta; beta.
standard deviation.
3. A highly risk-averse investor is considering adding one additional
2. The coefficient of variation, calculated as the standard deviation
stock to a 3- stock portfolio, to form a 4-stock portfolio. The three
of expected returns divided by the expected return, is a
stocks currently held all have b = 1.0, and they are perfectly
standardized measure of the risk per unit of expected return.
positively correlated with the market. Potential new Stocks A and
B both have expected returns of 15%, are in equilibrium, and are
3. The standard deviation is a better measure of risk than the
equally correlated with the market, with r = 0.75. However, Stock
coefficient of variation if the expected returns of the securities being
A's standard deviation of returns is 12% versus 8% for Stock B.
compared differ significantly.
Which stock should this investor add to his or her portfolio, or does
the choice not matter?
4. Risk-averse investors require higher rates of return on
investments whose returns are highly uncertain, and most investors
a. Either A or B, i.e., the investor should be indifferent between the
are risk averse.
two.
b. Stock A.
5. When adding a randomly chosen new stock to an existing
c. Stock B.
portfolio, the higher (or more positive) the degree of correlation
d. Neither A nor B, as neither has a return sufficient to compensate
between the new stock and stocks already in the portfolio, the less
for the risk.
the additional stock will reduce the portfolio's risk.
e. Add A, since its beta must be lower.
6. Diversification will normally reduce the riskiness of a portfolio of
4. Which of the following is NOT a potential problem when
stocks.
estimating and using betas, i.e., which statement is FALSE?
7. In portfolio analysis, we often use ex post (historical) returns and
a. The fact that a security or project may not have a history that can
standard deviations, despite the fact that we are really interested in
be used as the basis for calculating beta.
ex ante (future) data.
b. Sometimes, during a period when the company is undergoing a
8. The realized return on a stock portfolio is the weighted average of
change such as toward more leverage or riskier assets, the
the expected returns on the stocks in the portfolio.
calculated beta will be drastically different from the "true" or
"expected future" beta.
9. Market risk refers to the tendency of a stock to move with the
general stock market. A stock with above-average market risk will
c. The beta of an "average stock," or "the market," can change over
tend to be more volatile than an average stock, and its beta will be
time, sometimes drastically.
greater than 1.0.
d. Sometimes the past data used to calculate beta does not reflect
10. An individual stock's diversifiable risk, which is measured by its
the likely risk of the firm for the future because conditions have
beta, can be lowered by adding more stocks to the portfolio in which
changed.
the stock is held.
e. The beta coefficient of a stock is normally found by regressing
Activity 2.
past returns on a stock against past market returns. This calculated
historical beta may differ from the beta that exists in the future.
1. You have the following data on three stocks:
5. Which of the following statements is CORRECT?

a. The beta of a portfolio of stocks is always smaller than the beta of

any of the individual stocks.

If you are a strict risk minimizer, you would choose Stock ____ if it b. If you found a stock with zero historical beta and held it as the
is to be held in isolation and Stock ____ if it is to be held as part of only stock in your portfolio, you would by definition have a riskless
a well-diversified portfolio. portfolio.

a. A;A c. The beta coefficient of a stock is normally found by regressing past

b. A;B returns on a stock against past market returns. One could also
construct a scatter diagram of returns on the stock versus those on STOCKS AND THEIR VALUATION
the market, estimate the slope of the line of best fit, and use it as
beta. However, this historical beta may differ from the beta that 1. Proxy. A document giving one person the authority to act for
exists in the future. another, typically the power to vote for shares of common stock.
2. Proxy Fight. An attempt by a person or group to gain control of a
d. The beta of a portfolio of stocks is always larger than the beta of firm by getting its stockholders to grant that person or group the
any of the individual stocks. authority to vote their shares to replace the current management.
3. Takeover. An action whereby a person or group succeeds in
e. It is theoretically possible for a stock to have a beta of 1.0. If a ousting a firm’s management and taking control of the company.
stock did have a beta of 1.0, then, at least in theory, its required rate 4. Preemptive Right. A provision in the corporate charter or bylaws
of return would be equal to the risk-free (default-free) rate of that gives common stockholders the right to purchase on a pro rata
return, rRF. basis new issues of common stock or convertible securities.
5. Classified Stock. Common stock that is given a special designation
6. Taggart Inc.'s stock has a 50% chance of producing a 25% return, (Class A, Class B, etc.) to meet special needs of the company.
a 30% chance of producing a 10% return, and a 20% chance of 6. Founders’ Shares. Stock owned by the firm’s founders has sole
producing a −28% return. What is the firm's expected rate of voting rights but restricted dividends for a specified number of
return? years.
7. Market Price (P0). The price at which a stock sells in the market.
a. 9.41% 8. Intrinsic Value ( ). The value of an asset that, in the mind of a
b. 9.65% particular investor, is justified by the facts. This might be different
c. 9.90% from the asset’s current market price.
d. 10.15% 9. Growth Rate (g). The expected rate of growth in dividends per
e. 10.40% share.
10. Required Rate of Return (rs). The minimum rate of return on a
7. Dothan Inc.'s stock has a 25% chance of producing a 30% return, common stock that a stockholder considers acceptable.
a 50% chance of producing a 12% return, and a 25% chance of 11. Expected Rate of Return. The rate of return on a common stock
producing a −18% return. What is the firm's expected rate of that a stockholder expects to receive in the future.
return? 12. Actual Realized Rate of Return. The rate of return on a common
stock actually received by stockholders in some past period.
a. 7.72% 13. Dividend Yield. The expected dividend is divided by the current
b. 8.12% price of a share of stock.
c. 8.55% 14. Capital Gains Yield. The capital gain during a given year is
d. 9.00% divided by the beginning price.
e. 9.50% 15. Expected Total Return. The sum of the expected dividend yield
and the expected capital gains yield.
8. Cheng Inc. is considering a capital budgeting project that has an 16. Constant Growth (Gordon) Model. Used to find the value of a
expected return of 25% and a standard deviation of 30%. What is constant growth stock.
the project's coefficient of variation? 17. Zero Growth Stock. A common stock whose future dividends are
not expected to grow at all. (g=0)
a. 1.20 18. Supernormal (Nonconstant) Growth. The part of the firm’s life
b. 1.26 cycle in which it grows much faster than the economy as a whole.
c. 1.32 19. Terminal Date (Horizon Date). The date when the growth rate
d. 1.39 becomes constant. On this date, it is no longer necessary to forecast
e. 1.46 the individual dividends.
20. Horizon (Terminal) Value. The value at the horizon date of all
9. Bae Inc. is considering an investment that has an expected dividends expected thereafter.
return of 15% and a standard deviation of 10%. What is the 21. Total Company or Corporate Valuation Model. A valuation
investment's coefficient of variation? model is used as an alternative to the dividend growth model to
determine the value of a firm, especially one with no history of
a. 0.67 dividends or a division of a larger firm. This model first calculates the
b. 0.73 firm’s free cash flows and then finds their present value to
c. 0.81 determine the firm’s value.
d. 0.89 22. Marginal Investor. A representative investor whose actions
e. 0.98 reflect the beliefs of those people who are currently trading a stock.
It is the marginal investor who determines a stock’s price.
10. Bill Dukes has $100,000 invested in a 2-stock portfolio. $35,000 23. Equilibrium. A condition under which the expected return on a
is invested in Stock X and the remainder is invested in Stock Y. X's security is just equal to its required return and the price is stable.
beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta?
While it is generally easy to predict the cash flows received from
a. 0.65 bonds, forecasting the cash flows on common stocks is much more
b. 0.72 difficult.
c. 0.80
d. 0.89 1. FACTS ABOUT COMMON STOCK.
e. 0.98
1.1. Represents ownership
1.2. Ownership implies control ● Illustration. If rRF = 7%, rM = 12%, b=1.2, D0 = P2.00 and g is a
1.3. Stockholders elect directors constant 6% what is the stock’s intrinsic value?
1.4. Directors elect management
1.5. Management’s Goal: Maximize stock price

2. TYPES OF COMMON STOCK. Most of the firms have only one type
of common stock. However, some firms have:

2.1. Classified Stock. Common stock that is given a special

designation, such as Class A, Class B, etc., to meet special needs of
the company.

2.2. Founders’ Shares. Stock owned by the firm’s founders has sole
voting rights but restricted dividends for a specified number of
years.

3. INTRINSIC VALUE AND STOCK PRICE. Outside investors, corporate

insiders and analysts use a variety of approaches to estimate a
stock’s intrinsic value (P0).

3.1. Equilibrium. In equilibrium, we assume that a stock’s price

equals its intrinsic value. Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy and/or sell.
4.1.2. Zero Growth Stock.
3.1.1. Undervalued Stocks. Stock Price < Intrinsic Value
3.1.2. Overvalued Stocks. Stock Price > Intrinsic Value
● Illustration. What would be the expected price today if the stock’s
expected return is 13%, D0 = 2.00 and no growth?
3.2. Determinants of Intrinsic Value and Stock Prices.

4.1.3. Supernormal Growth.

● Illustration. What would be the expected price today if the stock’s

expected return is 13%, D0 = 2.00 and growth is 30% for 3 years
4. DIFFERENT APPROACHES FOR ESTIMATING THE INTRINSIC VALUE before achieving long-run growth of 6%?
OF A COMMON STOCK.

4.1. Discounted Dividend Model. The value of a stock is the present

value of the future dividends expected to be generated by the
stock.

4.1.1. Constant Growth Stock. A stock whose dividends are expected

to grow forever at a constant rate, g.
4.1.4. Zero-Growth at the Beginning Before Achieving Long-Run
Growth.

● Illustration. What would be the expected price today if the stock’s

expected return is 13%, D0 = 2.00 and growth is 0% for 3 years
before achieving long-run growth of 6%?

4.2.3. Illustration 1. Calculate the intrinsic value of a stock that has

WACC of 10% and a long-run growth of 6% after 3-years with this
FCF:

4.1.5. Negative Growth.

● Illustration. What would be the expected price today if the stock’s

expected return is 13%, D0 = 2.00 and growth is -6%?
4.2.4. Illustration 2. What is the firm’s intrinsic value per share if the
firm has $40 million total in debt and preferred stock and has 10
million shares of common stock?

4.3. Firm Multiples Method. Analysts often use the following

multiples to value stocks:
4.2. Corporate Valuation Model. It is called the free cash flow
method. It suggests the value of the entire firm equals the present
value of the firm’s free cash flows. Free Cash Flow is the firm’s after-
tax operating income less the net capital investment.

4.3.1. Example. Based on comparable firms, estimate the

appropriate P/E. Multiply this by expected earnings to back out an
4.2.1. Market Value of the Firm. estimate of the stock price.

4.4. EVA Approach. Economic Value-Added Approach.

4.2.2. Issues Regarding the Corporate Valuation Model.

5. PREFERRED STOCKS. These are hybrid securities. Like bonds,

preferred stockholders receive a fixed dividend that must be paid
before dividends are paid to common stockholders. However, a. The constant growth model is often appropriate for evaluating
companies can omit preferred dividend payments without fear of start-up companies that do not have a stable history of growth but
pushing the firm into bankruptcy. are expected to reach stable growth within the next few years.

5.1. Illustration. If preferred stock with an annual dividend of $5 b. If a stock has a required rate of return rs = 12% and its dividend is
sells for $50, what is the preferred stock’s expected return? expected to grow at a constant rate of 5%, this implies that the
stock's dividend yield is also 5%.

c. The stock valuation model, P0 = D1/(rs − g), can be used to value

firms whose dividends are expected to decline at a constant rate,
i.e., to grow at a negative rate.

d. The price of a stock is the present value of all expected future

dividends, discounted at the dividend growth rate.

e. The constant growth model cannot be used for a zero growth

stock, where the dividend is expected to remain constant over time.
Activity 1.
2. An increase in a firm's expected growth rate would cause its
1. A proxy is a document giving one party the authority to act for
required rate of return to
another party, including the power to vote shares of common stock.
Proxies can be important tools relating to control of firms.
a. increase.
b. decrease.
2. The preemptive right gives current stockholders the right to
c. fluctuate less than before.
purchase, on a pro rata basis, any new shares issued by the firm.
d. fluctuate more than before.
This right helps protect current stockholders against both dilution of
e. possibly increase, possibly decrease, or possibly remain constant.
control and dilution of value.
3. If in the opinion of a given investor a stock's expected return
3. Classified stock differentiates various classes of common stock,
exceeds its required return, this suggests that the investor thinks
and using it is one way companies can meet special needs such as
when owners of a start-up firm need additional equity capital but
a. the stock is experiencing supernormal growth.
don't want to relinquish voting control.
b. the stock should be sold.
c. the stock is a good buy.
4. Founders' shares are a type of classified stock where the shares
d. management is probably not trying to maximize the price per
are owned by the firm's founders, and they generally have more
share.
votes per share than the other classes of common stock.
e. dividends are not likely to be declared.
5. The total return on a share of stock refers to the dividend yield
4. If markets are in equilibrium, which of the following conditions
less any commissions paid when the stock is purchased and sold.
will exist?
6. The cash flows associated with common stock are more difficult to
a. Each stock's expected return should equal its realized return as
estimate than those related to bonds because stock has a residual
seen by the marginal investor.
claim against the company versus a contractual obligation for a
bond.
b. Each stock's expected return should equal its required return as
seen by the marginal investor.
7. When a new issue of stock is brought to the market, it is the
marginal investor who determines the price at which the stock will
c. All stocks should have the same expected return as seen by the
trade.
marginal investor.
8. According to the nonconstant growth model discussed, the
d. The expected and required returns on stocks and bonds should be
discount rate used to find the present value of the expected cash
equal.
flows during the initial growth period is the same as the discount
rate used to find the PVs of cash flows during the subsequent
e. All stocks should have the same realized return during the coming
constant growth period.
year.
9. The corporate valuation model can be used only when a company
5. Stocks A and B have the following data. Assuming the stock
doesn't pay dividends.
market is efficient, and the stocks are in equilibrium, which of the
following statements is CORRECT?
10. Preferred stock is a hybrid—a sort of cross between a common
stock and a bond—in the sense that it pays dividends that normally
increase annually like a stock, but its payments are contractually
guaranteed like interest on a bond

Activity 2.
a. These two stocks should have the same price.
1. Which of the following statements is CORRECT? b. These two stocks must have the same dividend yield.
c. These two stocks should have the same expected return.
d. These two stocks must have the same expected capital gains yield.
e. These two stocks must have the same expected year-end
dividend.
6. Stocks A and B have the following data. Assuming the stock
market is efficient, and the stocks are in equilibrium, which of the
following statements is CORRECT?
11. Based on the corporate valuation model, Chase Inc.'s total
corporate value is P300 million. The balance sheet shows P90
million of notes payable, P30 million of long-term debt, P40 million
of preferred stock, and P100 million of common equity. The
company has 10 million shares of stock outstanding. What is the
best estimate of the stock's price per share?
a. P12.00
b. P12.64
c. P13.30
d. P14.00
e. P14.70

12. Sunnier Corp.'s expected year-end dividend is D1 = P1.60, its

a. The two stocks should have the same expected dividend.
required return is rs = 11.00%, its dividend yield is 6.00%, and its
b. The two stocks could not be in equilibrium with the numbers
growth rate is expected to be constant in the future. What is
given in the question.
Sorenson's expected stock price in 7 years?
c. A's expected dividend is $0.50.
d. B's expected dividend is $0.75.
a. P37.52
e. A's expected dividend is $0.75, and B's expected dividend is $1.20.
b. P39.40
c. P41.37
7. Stocks A and B have the same price and are in equilibrium, but
d. P43.44
Stock A has the higher required rate of return. Which of the
e. P45.61
following statements is CORRECT?
13. Baker Inc.'s stock has a required rate of return of 10.25%, and it
a. If Stock A has a lower dividend yield than Stock B, its expected
sells for P57.50 per share. The dividend is expected to grow at a
capital gains yield must be higher than Stock B's.
constant rate of 6.00% per year. What is the expected year-end
b. Stock B must have a higher dividend yield than Stock A.
dividend, D1?
c. Stock A must have a higher dividend yield than Stock B.
d. If Stock A has a higher dividend yield than Stock B, its expected
a. P2.20
capital gains yield must be lower than Stock B's.
b. P2.44
e. Stock A must have both a higher dividend yield and a higher
c. P2.69
capital gains yield than Stock B.
d. P2.96
e. P3.25
8. Two constant growth stocks are in equilibrium, have the same
price, and have the same required rate of return. Which of the
14. Better Inc.'s stock has a required rate of return of 11.50%, and
following statements is CORRECT?
it sells for P25.00 per share. Goode's dividend is expected to grow
at a constant rate of 7.00%. What was the last dividend, D0?
a. The two stocks must have the same dividend per share.
b. If one stock has a higher dividend yield, it must also have a lower
a. P0.95
dividend growth rate.
b. P1.05
c. If one stock has a higher dividend yield, it must also have a higher
c. P1.16
dividend growth rate.
d. P1.27
d. The two stocks must have the same dividend growth rate.
e. P1.40
e. The two stocks must have the same dividend yield.
15. Senheiser Corporation just paid a dividend of D0 = P0.75 per
9. Yong Company's last dividend was P1.25. The dividend growth
share, and that dividend is expected to grow at a constant rate of
rate is expected to be constant at 15% for 3 years, after which
6.50% per year in the future. The company's beta is 1.25, the
dividends are expected to grow at a rate of 6% forever. If the firm's
required return on the market is 10.50%, and the risk-free rate is
required return (rs) is 11%, what is its current stock price?
4.50%. What is the company's current stock price?
a. P30.57
a. P14.52
b. P31.52
b. P14.89
c. P32.49
c. P15.26
d. P33.50
d. P15.64
e. P34.50
e. P16.03
10. William's preferred stock pays a dividend of P1.00 per quarter.
If the price of the stock is P45.00, what is its nominal (not effective)
annual rate of return?

a. 8.03%
b. 8.24%
c. 8.45%
d. 8.67%
e. 8.89%