Chapter 10

Discussion Questions

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 rent received by investors for giving up use of their funds, above inflation and without a risk premium.

6. If inflationary expectations increase, the yield to maturity (required rate of return) will increase. This will mean a lower bond price.

7. The longer the time period remaining to maturity, the greater the impact of a difference between the rate the bond is paying and the current yield to maturity (required rate of return). For example, a two percent ($20) differential is not very significant for one year, but very significant for 20 years. In the latter case, it will have a much greater effect on the bond price.

8. The valuation models represent the complex real world in a simplified manner. As such they are incomplete. If we can keep the other components of the model constant, then the model will hinge on the investor’s required or expected rate of return. Three components of an investor’s required rate of return have been suggested. If a change in an investor’s required return can be fully captured, the model will work. For practical purposes holding other factors constant and fully capturing changes in investor expectations and psychology proves