Question

2.(40 marks) State whether each of the following statements is True/False. Justify your answer. a) (5 marks) Internal rate of return is the discount rate that balances the sum of present values of cash flows associated with the bond with its face value. b) (5 marks) To find the yield to maturity you must assume that investor is able to reinvest all payoffs from the bond at this same rate. c) (5 marks) In valuing a security, we only need to know what the future cash flows will be. d) (5 marks) The amount a bond actually sells for may be higher or lower than its face value. e) (5 marks) Common stocks that pay no dividends are generally priced lower than dividend paying stocks. f) (5 marks) There is more uncertainty associated with the future returns of common stocks than with the returns of bonds and preferred stock. B) (5 marks) When interest rates go up, the market price of a bond goes up. h) (5 marks) The yield on common stock comes from two sources: the dividend yield and the capital gains yield.

Answer 1

Solution a)

FALSE

The internal rate of return is the return that equates the present value of cash flows to the Bond Price and not to Face value.

In the case of bonds, generally, the internal rate of return is the Yield to maturity rate also known as promised yield.

Solution b)

TRUE

Because YTM is the rate of return that a bondholder will earn if the bond is held to maturity and the interest payments are reinvested at the YTM rate.

Solution c)

FALSE

In valuing security we need to know two things:

• the future cash flows; and
• the required rate of return to discount the cash flow

Solution d)

TRUE

The price of a bond is the sum total of present values of all coupon payments and present value of maturity value. The required rate of return is YTM and we discount the cash flows of the Bond using YTM. Since rate of YTM can vary up or down than the coupon rate hence, the Bond price will go up or below the Face Value