Question 1

There is a negative correlation between risk and the return investors demand.
There is a strong positive correlation between risk taken by investors and the return demanded by investors.

Accepted Answer

There is a positive correlation between risk and return; investors typically demand higher returns for taking on more risk.

Question 2

Preferred stock may not having the same ownership privileges as common stock, but preferred stock is offered a fixed dividend stream supported by a binding contractual obligation.
Preferred stock DOES have a fixed dividend stream, but does not carry a binding contractual obligation, as does debt.

Accepted Answer

Preferred stock does have a binding contractual obligation for payment of the fixed dividend, but it is not the same as the obligation in debt contracts. Debt contracts have a legal obligation for repayment of principal and interest, whereas preferred stock dividends are paid before common stock dividends but are not legally binding obligations.

Question 3

The "risk premium" is primarily concerned with business risk, financial risk, and inflation risk.
The risk premium includes the business and financial risk elements only.

Accepted Answer

The risk premium includes business risk, financial risk, and inflation risk.

Question 4

The longer the maturity of a bond, the greater the impact on price to changes in market interest rates.

Accepted Answer

This is because longer-term bonds are more sensitive to changes in market interest rates as they have a higher duration. Duration is a measure of the sensitivity of the bond's price to changes in interest rates. Therefore, when interest rates rise, the price of a longer-term bond falls more than the price of a shorter-term bond.

Question 5

The "risk-free rate of return" is equal to the inflation premium plus the real rate of return.

Accepted Answer

The risk-free rate of return is defined as the rate of return on an investment with zero risk, such as a government bond. It is calculated as the inflation premium plus the real rate of return, which represents the growth in purchasing power of the investment. Therefore, the statement is true.

Question 6

As time to maturity increases, bond price sensitivity decreases.

Accepted Answer

As time to maturity increases, a bond's price becomes more sensitive to changes in interest rates, meaning its price is more likely to fluctuate with interest rate movements.

Question 7

When inflation rises, preferred stock prices fall.

Accepted Answer

Preferred stock prices are sensitive to changes in interest rates. When inflation rises, central banks tend to raise interest rates to control it, which leads to a decrease in the demand for preferred stocks, causing their prices to fall.

Question 8

Preferred stock would be valued the same as a common stock with a zero dividend growth rate.

Accepted Answer

Preferred stock, like common stock, is valued using the dividend discount model. If a preferred stock is assumed to have a constant dividend payment, then it can be valued in the same way as a common stock with a zero dividend growth rate.

Question 9

An increase in inflation will cause a bond's required return to rise.

Accepted Answer

As inflation increases, the purchasing power of a bond's fixed payments decreases. Investors will demand a higher required return to compensate for the loss in purchasing power, causing bond prices to fall and yields to rise.

Question 10

The inflation premium is based on past and current inflation levels.

Accepted Answer

The inflation premium is primarily based on expectations of future inflation, not just past or current levels.

Question 11

The closer the yield to maturity on a bond to the stated rate, the closer to par the bond will trade.

Accepted Answer

This statement is true because yield to maturity takes into account both the coupon rate and the price of the bond. If the yield to maturity is equal to the stated rate, then the bond is trading at par value. If the yield to maturity is higher than the stated rate, then the bond is trading at a discount. If the yield to maturity is lower than the stated rate, then the bond is trading at a premium. Therefore, the closer the yield to maturity is to the stated rate, the closer the bond will trade to par value.

Question 12

The higher the yield to maturity on a bond, the closer to par the bond will trade.
Increasing the yield to maturity will increase the difference between the par value and the price that buyers are willing to pay for it.

Accepted Answer

As the yield to maturity on a bond increases, the price of the bond will decrease because the bond becomes less valuable to potential buyers. Therefore, the bond will trade farther away from par.

Question 13

The variable growth model is most useful for firms in emerging industries.

Accepted Answer

The variable growth model is best suited for firms in emerging industries because it allows for flexibility and adaptability to changing market conditions and consumer preferences. Established firms in mature industries may find other models, such as the steady-state or incremental growth model, to be more appropriate for their needs.

Question 14

When inflation rises, bond sales prices fall.

Accepted Answer

When inflation rises, the value of future cash flows decreases, which reduces the value of bonds that pay a fixed interest rate. As a result, bond prices fall.

Question 15

The price of preferred stock is determined by dividing the fixed dividend payment by the required rate of return.

Accepted Answer

The price of preferred stock is determined by dividing the fixed dividend payment by the required rate of return, also known as the dividend yield. This calculation provides the present value of the preferred stock's future cash flows, which determines its market price.

Question 16

The risk premium is equal to the required yield to maturity (or rate of return) minus both the real rate of return and the inflation premium.

Accepted Answer

This is the correct definition of the risk premium.

Question 17

The further the yield to maturity of a bond moves away from the bond's coupon rate, the greater the price-change effect will be.

Accepted Answer

This is because the yield to maturity and the coupon rate have an inverse relationship, meaning that as the yield to maturity increases or decreases, the bond price will move in the opposite direction. Therefore, if the yield to maturity is significantly different from the coupon rate, the price of the bond will be affected more.

Question 18

"Business risk" relates to the inability of the firm to meet its debt obligations as they come due.
Financial risk relates to the inability to meet debt obligations.

Accepted Answer

The statement mistakenly swaps the definitions of business and financial risk. Business risk actually pertains to the risk of the firm's inability to generate profits or revenue, while financial risk pertains to the risk of the firm's inability to meet its debt obligations.

Question 19

Risk premiums are higher for riskier securities, but the risk premium cannot be higher than the required rate of return.

Accepted Answer

The risk premium represents the additional compensation an investor demands to invest in a riskier security compared to a less risky security. However, the risk premium cannot be higher than the required rate of return as the required rate of return incorporates factors such as the risk-free rate, inflation, and the specific risk associated with the security.

Question 20

High-risk corporate bonds can be as risky as junk bonds.

Accepted Answer

High-risk corporate bonds are typically rated below investment grade and therefore carry a higher risk of default. Junk bonds, also known as high-yield bonds, are a type of below investment grade bond and have a higher risk of default. Therefore, high-risk corporate bonds can be as risky as junk bonds.

Quiz 10: Valuation and Rates of Return

There is a negative correlation between risk and the return investors demand. There is a strong positive correlation between risk taken by investors and the return demanded by investors.

Preferred stock may not having the same ownership privileges as common stock, but preferred stock is offered a fixed dividend stream supported by a binding contractual obligation. Preferred stock DOES have a fixed dividend stream, but does not carry a binding contractual obligation, as does debt.

The "risk premium" is primarily concerned with business risk, financial risk, and inflation risk. The risk premium includes the business and financial risk elements only.