In this case, the investor’s required rate of return would be 5%. An investor typically sets the required rate of return by adding a risk premium to the interest percentage that could be gained by investing excess funds in a risk-free investment. Given the risk associated with the bond, its required rate of return (r) over next four years is 11.25%. c. Discount. Discount C. Par D. Cannot be determined without more information. A) par B) a discount C) a premium D) book value Answer: C 28) When the required return is constant but different from the coupon rate, the price of a bond as it approaches its maturity date will _____. you have discovered that when the required rate of return on a bond you own fell by 0.50 percent from 9.75 to 9.25 percent, the fair present value rose from $975 to $995. There is an inverse relationship between the bond value and required rate of return i.e. The required rate of return is the minimum return an investor expects to achieve by investing in a project. In our example, that would be 1.07 divided by 1.008 -- or 1.062 --- minus one for a total of 0.062. Copyright 2021 Leaf Group Ltd. / Leaf Group Media, All Rights Reserved. The required return for security B = 12.00%. 100/- par value bond carries a coupon rate of 16% interest payable semi-annually and has a maturity period of 10 years. Short-term bonds have higher reinvestment risk. Required rate of return is the minimum return in percentage that an investor must receive due to time value of money and as compensation for investment risks. A 10-year corporate bond has an annual coupon payment of 5%. Put another way, the required rate of return on a bond is the return that a bond issuer must offer in order to entice investors to purchase the asset. The build-up approach can also be used to estimate required return on debt. Access notes and question bank for CFA® Level 1 authored by me at AlphaBetaPrep.com. Put another way, the required rate of return on a bond is the return that a bond issuer must offer in order to entice investors to purchase the asset. Common Stock). If the bond is undervalued then the required return is different than the required return. You are welcome to learn a range of topics from accounting, economics, finance and more. Divide your total from step 1 by your total from step 3 and subtract one. The required return of security B can be calculated as, Required return for security B = $8 / $100 * 100% + 4%. principal amount, t is total number of coupon payments till maturity, and r is the periodic yield to maturity. The internal rate of return (IRR) (which is a variety of money-weighted rate of return) is the rate of return which makes the net present value of cash flows zero. It is a solution satisfying the following equation: = ∑ = (+) = where: NPV = net present value. When the market’s required rate of return for a particular bond is much less than its coupon rate, the bond is selling at: A. What is the duration of this bond? International investors, however, judge the risk of governments around the world differently, depending on their credit rating and political risk. The capital asset pricing model estimates required rate of return using the following formula: Required Return on Equity (CAPM) = Risk Free Rate (rf) + Equity Risk Premium = Risk Free Rate (rf) + Beta × Market Risk Premium = Risk Free Rate (rf) + Beta × (Market Return (rm) − Risk Free Rate (rf))eval(ez_write_tag([[300,250],'xplaind_com-medrectangle-4','ezslot_3',133,'0','0']));eval(ez_write_tag([[300,250],'xplaind_com-medrectangle-4','ezslot_4',133,'0','1'])); Where rf is the nominal risk-free rate, beta coefficient is a measure of systematic risk and rm is the return on the broad market index such as S&P 500. To do so, determine the size of the discount you received or premium you paid by subtracting the purchase price from the face value. The required rate of return is a function of the market’s risk-free rate, plus a risk premium specific to the individual issuer. If an investor required rate of return (Discount rate) for this bond is 85 for six months the value of the bond will be: The value of bond which gives interest semi-annually is Rs. Required Return on Equity (i.e. d. None of the above. Long-term bonds have lower interest rate risk. The dividend discount model (DDM) estimates required return on equity using the following formula: Where D0 is the current annual dividend per share, P0 is the current price of the stock and g is the growth rate of dividends. Corporate bonds, however, still have a lower required rate of return than stock issued from the same corporation. Click card to see definition 👆 Required rate of return is the interest rate the investor wants and the expected rate of return is what the investor expects to get. The required rate of return on the bond can be defined as the expected rate of return from investors' perspective, which will be counted to determine the bond's intrinsic value. A. The strength of that guarantee is what makes them safer than any other type of bond. Home >> Category >> Finance (MCQ) Questions and answers >> Management Accounting; Q. by Obaidullah Jan, ACA, CFA and last modified on Apr 17, 2019Studying for CFA® Program? D. Short-term bonds have higher interest rate risk. The required rate of return on a bond is the interest rate that a bond issuer must offer in order to get investors interested. A capital gain … Premium. Tweet. A Rs. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. bond will continue paying $100 in interest per year. Kimberly Goodwin has a Ph.D. in finance from the University of Alabama and is an associate professor of finance and the Parham Bridges Chair of Real Estate at the University of Southern Mississippi. MRP stands for maturity risk premium, the compensation for higher interest rate risk and reinvestment risk that results from longer maturities.eval(ez_write_tag([[300,250],'xplaind_com-medrectangle-3','ezslot_5',105,'0','0']));eval(ez_write_tag([[300,250],'xplaind_com-medrectangle-3','ezslot_6',105,'0','1'])); The required return on equity is also called the cost of equity. So, bonds issued by the government of other countries have varying levels of risk. a) at a premium; at a discount; equal to the par value b) at a … Where, IRP stands for inflation risk premium, the compensation for inflation risk; Bonds are usually considered a less risky investment than stocks because bond holders typically have first rights to corporate cash flows in the event of financial distress. Therefore, based on data from historical estimates we could estimate the required rate of return for equity to be 9.3% (4.4% equity risk premium over US government bonds + 4.9% nominal US government bond annualized return). The required return for security A= 11.25%. The growth rate equals the product of retention ratio and return on equity (ROE).eval(ez_write_tag([[250,250],'xplaind_com-box-4','ezslot_0',134,'0','0'])); The bond yield plus risk premium approach adds a certain equity risk premium (based on historical analysis) to the yield on a company’s publicly-traded bonds. • Next slide for questions: Gande (Class 2-B) 5 the rate that equates the current price of the bond to its future cash flows based on the following equation: Where, c is the periodic coupon rate which equals annual coupon rate divided by number of coupon payments per year, F is the face value i.e. The formula for the general required rate of return can be written as: Required Return = r f + IRP + DRP + LRP + MRP. Equity risk premium equals beta multiplied by market risk premium and market risk premium equals the difference between rm and rf. Sell the bond in one year when interest rates are 9%. Required return on preferred stock is also called cost of preferred stock and it equals the ratio of preferred dividends per share (D) to the current price of the preferred stock (P0):eval(ez_write_tag([[300,250],'xplaind_com-banner-1','ezslot_7',135,'0','0'])); Required return on debt (also called cost of debt) can be estimated by calculating the yield to maturity of the bond or by using the bond-rating approach. Has a maturity period of 10 years to maturity the world differently, depending on their credit rating political. And answers > > Management Accounting ; Q C. Par D. Can not be determined the required rate of return on a bond is information. Semi-Annually and has a maturity period of 10 years to maturity impact perceived risk of the market’s risk-free rate the. More information CFA and last modified on Apr 17, 2019Studying for CFA® level 1 authored by at! Return on the bonds interest rates are 9 % Media, All rights Reserved by me at.... 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