Question: Discounted Cash Flow
Exam 2 Part 2
Answer any EIGHT of the ten questions. Each question is worth 5 points.
Return your answers to me by 11:59 PM Sunday 11 November 2012 1. A number of publicly traded firms pay no dividends yet investors are willing to buy shares in these firms. How is this possible? Does this violate our basic principle of stock valuation? Explain.
Our basic principle of stock valuation is that the value of a share of stock is simply equal to the present value of all of the expected dividends on the stock. According to the dividend growth model, an asset that has no expected cash flows has a value of zero, so if investors are willing to purchase shares of stock in firms that pay no dividends, they evidently expect that the firms will begin paying dividends at some point in the future. 2. Explain why some bond investors are subject to liquidity risk, default risk, and/or taxability risk. How does each of these risks affect the yield of a bond?
Liquidity problems exist in thinly traded bonds making some bonds difficult to sell at their actual value. Default risk is the likelihood the corporation will default on its bond obligations. Taxability risk reflects the fact that some bonds are taxed disadvantageously compared to others. If any of these risks exist, investors will require compensation by demanding a high yield. 3. The discussion of asset pricing in the text suggests that an investor will be indifferent between two bonds which have equal yields to maturity as long as they have equivalent default risk. Can you think of any real-world factors which might make a given investor prefer one of these bonds over the other?
4. Why do corporations issue 100-year bonds, knowing that interest rate risk is highest for very long-term bonds? How does the interest rate risk affect the issuer?
Treasury bonds make great safe, long-term investments, but is there any point in Why would the Fed consider issuing a bond with a 100-year maturation, are
Answer any EIGHT of the ten questions. Each question is worth 5 points.
Return your answers to me by 11:59 PM Sunday 11 November 2012 1. A number of publicly traded firms pay no dividends yet investors are willing to buy shares in these firms. How is this possible? Does this violate our basic principle of stock valuation? Explain.
Our basic principle of stock valuation is that the value of a share of stock is simply equal to the present value of all of the expected dividends on the stock. According to the dividend growth model, an asset that has no expected cash flows has a value of zero, so if investors are willing to purchase shares of stock in firms that pay no dividends, they evidently expect that the firms will begin paying dividends at some point in the future. 2. Explain why some bond investors are subject to liquidity risk, default risk, and/or taxability risk. How does each of these risks affect the yield of a bond?
Liquidity problems exist in thinly traded bonds making some bonds difficult to sell at their actual value. Default risk is the likelihood the corporation will default on its bond obligations. Taxability risk reflects the fact that some bonds are taxed disadvantageously compared to others. If any of these risks exist, investors will require compensation by demanding a high yield. 3. The discussion of asset pricing in the text suggests that an investor will be indifferent between two bonds which have equal yields to maturity as long as they have equivalent default risk. Can you think of any real-world factors which might make a given investor prefer one of these bonds over the other?
4. Why do corporations issue 100-year bonds, knowing that interest rate risk is highest for very long-term bonds? How does the interest rate risk affect the issuer?
Treasury bonds make great safe, long-term investments, but is there any point in Why would the Fed consider issuing a bond with a 100-year maturation, are