NET PRESENT VALUE
Only if the net present value calculation of an investment is greater than $0, is it considered a good investment. The higher the discount rate (assumed rate of return) used, the lower the net present value. The lower the discount rate used, the higher the net present value.
If Joe Schmo, an investor, calculates that the present value of $1,000 invested at 8% for five years is $1,100, he would probably make the investment since the present value of the future cash flow exceeds his initial investment. (Net present value is found by subtracting the current amount to be invested -- $1,000 -- from the calculated present value of $1,100. The net present value of the investment is $100.)
Place the business risk of the following investors in the proper sequence from highest to lowest.
I. Holders of common stock
II. Holders of mortgage bonds
III. Holders of debentures
IV. Holders of preferred stock
A) I, II, III, IV, V
B) I, IV, III, II, V
C) V, IV, I, II, III
D) III, IV, I, V, II
•For the test, it is not the length of the bond that determines the interest rate risk; rather, it is the decision to sell the bond that causes the interest-rate risk.
•If a test question states that the bond will not be sold prior to maturity, ELIMINATE interest-rate risk as a possible answer.
•Do not try to determine if the bond is long or short term, but look to see if the bond is going to be held or sold prior to maturity.
•All bonds, long and short-term, have interest-rate risk. But they only have interest-rate risk if they are to be sold.
•The market price of bonds may be affected by business risk and supply and demand in the market, but the most common factor that affects the prices of bonds are changes in interest rates.
•The coupon interest rates for companies with high business risks are higher to compensate for this increased risk.
•Changes in interest rates can also affect the stock market, especially preferred stock. For this reason, preferred stock also has interest-rate risk, due to the fact there is no maturity date. This has a two-fold effect: Rising interest rates increase the cost of borrowing for companies, which lowers their returns and the rising interest rates make bonds less attractive to investors.
Market risk, sometimes referred to as systematic risk, is common to all equity securities (stock), and it usually cannot be eliminated by diversification. It is the biggest risk when investing in equity securities. Inflation risk exists for all long-term debt securities, but not for equity securities. Market risk can pertain to both. Business risk is the chance that a company may go bankrupt due to changes in the economy and /or the industry of that company. The company could be forced to liquidate its assets and the investor would lose all, or part, of their investment. Regulatory risk exists for all securities that are subject to governmental regulation, such as municipal bonds that could lose their tax-exempt status, or companies that are heavily regulated by the government, such as airlines. [Module 8, Risk and Evaluation, Sections 3.2 - 3.6]
Capital Asset Pricing Model.
According to the CAPM theory, investors can earn risk-free return by investing in savings accounts, bank CDs, and T-bills. Since most other investments carry at least some risk, CAPM states that an investment must create a return greater than the risk-free return in order to justify the additional risk involved. The correlation coefficient is a statistical measure of how two or more measurements relate to each other, (e.g., how interest rates affect the market values of certain bonds); risk-free return is return with little or no risk, (resulting in little or no growth), such as savings accounts, T-bills and CDs; this is an element of CAPM. Risk-adjusted return is the difference between the actual risk and the risk-free rate of return. [Module 8, Risk and Evaluation, Section 1.1]