Question

Discuss the risk-free rate. In your discussion include you should include a definition, how it is calculated and how and when it is used in finance.                                

Compare and contrast ordinary and preference shares and discuss how their return and value can be calculated.              

Answer 1

RISK FREE RATE

What is risk free rate?

Risk free rate is an imaginary rate. It is the minimum rate of return expected by the investors. If the actual return is lower than the risk free rate, the investors will not invest in that investment. In simple words, risk free rate is the rate of return that the investors expect from a zero risk investment. As the risk increases, the rate of return also increases.

Why is risk free rate an imaginary concept?

Risk free rate is an imaginary concept, because every investment has a least risk. Risk free rate is the rate of return on a zero risk investment. Zero risk investment itself is an theoretical concept.

How is it calculated?

Real risk free rate: Real risk free rate is the rate of return on investment without the influence of the inflation in the economy. Real risk free rate is computed using the given formula:

Nominal risk free rate: Nominal risk free rate is the rate of return on an investment in which there is an element of inflation in the economy. Nominal risk free rate is calculated using the given formula:

Uses of risk free rate:

1. Risk free rate is used in making investment decision.

2. It is used in the computation of the cost of capital.

3. It is used for the computation of weighted average cost of capital.

4. It is used in Black- Scholes Option pricing model.

5. It is used in modern portfolio theory.

6. It is used in Capital asset pricing model.

COMPARISON OF ORDINARY AND PREFERENCE SHARES

What is a share?

Share is a part of the ownership in a company. By purchasing shares, the investor will have ownership rights on the company. The person who acquires the shares is called the shareholder of the company.

Classification of Shares

Mainly, shares can be classified into:

1. Equity shares

2. Preference shares

Equity shares are also called ordinary shares. Equity shareholders are the owners of the company. they are the members. They have voting rights on the decisions of the board.

The Value of equity shares are calculated by:

Return on Equity shares is calculated by:

Where,

D₁ = Divident

P₀ = Price of the share

g = Growth rate

Preference shares are the shares for which there is a fixed divident payment. The preference shareholders will have a preference in the payment of divident. They have no voting right. They are not the members.

Value of Preference shares are computed by:

Where,

D = Divident

r = required rate of return of the shareholder

Return on irredeemable preference shares are calculated by:

Where,

Kp = cost of preference share capital or the return on the preference shares

Dp = Divident

NP = Net proceeds

Where,

Kp = Cost of preference capital or the return on the preference shares

Dp = Divident

Rv = Redeemable value

NP = Net proceeds