Question

In: Finance

In an effort to better understand how her investments are affected by market factors, Michelle Delatorre,...

In an effort to better understand how her investments are affected by market factors, Michelle Delatorre, the professional tennis player introduced in Integrative Problem 3-2 in Chapter 3, has posed some questions about yields and interest rates that she wants answered. Your boss at Balik and Kiefer has asked you to answer the following questions for Ms. Delatorre. a. What is the difference between the dollar return and the percentage return, or yield, on an investment? Show how each return is computed? b. Ms. Delatorre mentioned that she purchased a stock one year ago for $250 per share, and that the stock has a current market value equal to $240. She knows she received a dividend payment equal to $25, but she doesn’t know what rate of return she earned on her investment. Help Ms. Delatorre by showing her how to compute the rate of return on her investment. c. What do you call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? d. What is the real risk- free rate of interest (r*) and the nominal risk- free rate (rRF)? How are these two rates measured? e. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities.

Expert Solution

Answer a) the difference between the dollar return and the percentage return, or yield,

The percentage return is a time weighted return of the account, while The dollar return is the actual return on investment in dollar amount.Dollar return is the typical financial gain or loss on an investment and is typically expressed as the change in dollar value of an investment over time. The percentage return is generally expressed as an annual rate expressed in percentage based on the face value or invesment cost.

Dollar return = Selling price- purcahse price + Dividend recieved

Percentage return = (Selling price- purcahse price + Dividend recieved) / Purchase price * time

Answer b)
Ms. Delatorre

return = Selling price- purcahse price + Dividend recieved

= 240 -250+ 25= $15

Rate of return = 15/ 250 = 0.06 = 6 %

Answer C) the price that a borrower must pay for debt capital : Cost of Debt /Interest rate

the price of equity capital : Cost of Equity / Dividend Yield

the four fundamental factors that affect the cost of money: Production opportunities ,Time and preferences for consumption , Risk and Expected inflation rate

Answer D)

The real risk free interest rate is rate that exist on default free government securities in case of no inflation.

Nominal risk free interest rate is addition of inflation on existing real risk free interest rate.

Nominal rate = real rate + Inflation rate.

Answer E)

IP(inflation Premium) : The higher interest rate charged on and over inflation rate

DRP (Default risk premium):the difference between the interest rate on a Treasury bond and a corporate bond of equal time of maturity and marketability.

MRP (maturity risk premium) :a premium that reflects interest rate risk

LP(Liquidity Premium) :a interest premium of a security if that security cannot be converted to cash quickly and at close to fair market value.

r=r*+IP+DRP+LP+MRP

r=nominal rate, required return
r*=real risk-free rate of return
IP=inflation premium
DRP=default risk premium
LP=liquidity premium
MRP=maturity risk premium

jeff jeffy answered 2 years ago

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