Question

1. Explain why cash flows occurring at different times must be adjusted to reflect their value as of a common date before they can be compared, and be able to calculate the present value and future value of multiple cash flows
2. Explain the relationship between interest rates and bond prices. Why are long-term bonds more sensitive to changes in interest rates than shorter-term bonds?
3. How are preferred shares different from ordinary shares? How do you estimate the required rate of return of a preferred share if you know its market price and its dividend?
4. What is an Initial Public Offering (IPO)? What are its various advantages and disadvantages?
5. Discuss which type of risk matters to investors and why. In addition, describe how investing in more than one asset can reduce risk through diversification.
6. What does beta measure? How do we use beta? Describe and justify what the value of the beta of an Australian government bond should be.
7. According to the CAPM, the expected return on a risky asset depends on three components. Define each of these three components and explain the meaning of a beta value of 1.

Answer 1

Since you have asked multiple unrelated questions, I am answering first three of them. Please post the balance questions as separate individual questions.

1. Explain why cash flows occurring at different times must be adjusted to reflect their value as of a common date before they can be compared, and be able to calculate the present value and future value of multiple cash flows

Cash flows do have time value of money. A dollar today is more valuable than a dollar tomorrow. This is because a dollar received today:

• Can be reinvested to earn some return tomorrow and thus it can grow.
• Is certain while the dollar expected tomorrow has some level of uncertainty or riskiness associated with it.

Because of these reasons, there is no merit in directly comparing the cash flows occurring at different points of time. Their values today i.e.at a common date must be compared.Hence, cash flows occurring at different times must be adjusted to reflect their value as of a common date before they can be compared.

Present value of a future cash flow is that value of cash required today that will grow to the future value if invested at RRR. Hence, present value of a cash flow (CF_t) in period t (years) from now at a required rate of return of k is given by,

We can reverse the same formula to get the future value of a cash flow.

$FV(CF_{0}) = CF_{0}\times (1 + k)^{t}$

2. Explain the relationship between interest rates and bond prices. Why are long-term bonds more sensitive to changes in interest rates than shorter-term bonds?

Before answering the questions, let's try to understand the following concept:

• At any point in time, the value of a bond is present value of all the future coupon payments and principal repayment.
• And interest rate prevailing in the market is the proxy for the discount rate.

Thus bond prices are inversely and non linearly related to the interest rate.

Suppose I have two bonds one with 3 years maturity and another one with 8 year maturity. Suddenly interest rate increases, say at the end of two years from now. In the 3 year maturity bond, i will then have just one more year to go. I will be stuck with the bond for 1 more year and as soon as third year comes, i will get my principal back which i will reinvest at higher interest rate. In case of the 8 years maturity bond, I will be stuck for balance 6 years before i get my principal back to reinvest at a higher interest rate. Thus i have a higher interest rate risk in case of bond with a higher maturity. Thus, the interest-rate risk is positively associated with maturity.

Another way to look at it: For a bond with higher maturity, future coupon payments and principal repayments are relatively further away in future. When interest rate increases, these long distant coupon payments get discounted at a higher discount rate and they loses value significantly and thus result into lower value of the bond. The reduction in the bond price is sharper. It's true that increase in interest rate will have a similar impact on the price of a bond with lower maturity, but reduction in price there is not that sharp and abrupt. Thus, interest rate risk is prevalent in bonds of all kinds of maturities, but it's impact is more severe in case of bonds with higher maturity.

3. How are preferred shares different from ordinary shares? How do you estimate the required rate of return of a preferred share if you know its market price and its dividend?

Stock investment signifies an ownership position in an enterprise via preferred or common stock. The ownership gives a stockholder a claim on the assets and profits of the company but the claim is subordinated to all debt.

All stocks are not created equal. Companies offer two main types of stock: common and preferred stock, each with its share of advantages and disadvantages for investors.

Sl. No.	Parameter	Common Stock	Preferred Stock
1.	Ownership	Yes, they get a partial claim on the assets and profits of the company	Yes, they get a partial claim on the assets and profits of the company
2.	Voting Rights	Yes, they get to vote on important company matters such as election of BOD, important policy matters, merger and acquisition decisions, auditor’s appointment etc.	Generally and mostly No
3.	Dividend payments	Discretionary, quantum and timing not known inn advance	Usually guaranteed payments of dividends at a fixed rate although the company does not have to pay this dividend if it lacks the financial ability to do so. Not a legal or contractual obligation of the company and hence non-payment of preferred dividend is not treated as default. Unpaid dividends tend to accumulate (and said to be in arrears) in case of cumulative preferred stock. If the shares are not cumulative, the company does not have the obligation to pay missed dividends.
4.	Relative dividend	Lower	Higher
5.	Pecking order	Subordinated to debt and preferred capital, eligible to get dividend only when preference dividend (current as well as in arrears, if any) has been paid	Subordinated to debt; greater claim on the company’s assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders.
6.	Tradable	Yes	Yes
7.	Risk profile	Common stock tends to respond to general market volatility. Its level of risk also varies greatly by company.	Lower than common stock but higher than bonds
8.	Return	Common stocks have historically offered higher returns than preferred stocks or bonds. Downside is unprotected and upside is infinite.	Since preferred shares carry fixed dividend payments, they tend to fluctuate in price far less than common shares. This means that the opportunity for both large capital gains and large capital losses is limited. Downside risk is relatively better protected and upside is capped.
9.	Redeemable, callable, convertible	N.A.	May be, if redeemable – it will be redeemed at the end of agreed time and at agreed price. If callable, the company has the right to purchase the shares from the shareholder at a certain price at any time. If convertible, they will get converted to common shares @ the end of predetermined timeline @ predetermined ratio.
10.	Pre-emptive rights	Yes, allows shareholder to maintain their equity ownership if the company issues additional stock	N.A.
11.	Price fluctuations	Generally more	Relatively lesser
12.	Participating	N.A.	A participating feature in preferred stock allows the investor to participate in additional dividend if dividends that common shareholders receive exceeds a specified per-share amount.
13.	Maturity date	No maturity date	No maturity date unless it’s redeemable where mandatory redemption has been agreed upon
14.	Tax deductibility on dividends	Not tax deductible	Not tax deductible
15.	Nature	Pure equity	Hybrid

Required return on preferred stock = Cost of preferred stock (K_ps)

It refers to the cost of non-callable, nonconvertible preferred stock and is given by

$gcGBaFj8igPWwAAAABJRU5ErkJggg==$

Here the floatation cost “F” is expressed per share and in monetary terms. If it’s a %age of the share price denominator should be expressed as P_ps x (1 – F). Preference Dividend is not an allowable expenditure for tax purposes hence they don’t result into tax savings. In case the floatation cost is zero, the formula for required rate of return becomes:

$K_{ps} = \frac{Dividend}{Price}$