# the required rate of return on a bond is

Illustration 3: 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. b. Government-issued bonds are considered to have the lowest risk and therefore the lowest required rate of return. Corporate bonds have the highest risk and therefore the highest required rate of return. The required rate of return, discount rate and opportunity cost are introduced as possible ways to interpret a given interest rate. Required Rate of Return = (2.7 / 20000) + 0.064; Required Rate of Return = 6.4 % Explanation of Required Rate of Return Formula. â¢ Next slide for questions: Gande (Class 2-B) 5 In our example, that would be 1.07 divided by 1.008 -- or 1.062 --- minus one for a total of 0.062. Your real annual rate of return on your bond, adjusted for the 0.8 percent inflation that occurred during the year, is 6.2 percent. A capital gain â¦ The most basic framework is to estimate required rate of return based on the risk-free rate and add inflation premium, default premium, liquidity premium and maturity premium, whichever is applicable. Show Comments. Home >> Category >> Finance (MCQ) Questions and answers >> Management Accounting; Q. It involves adding inflation, default, liquidity and maturity premia to the real risk free rate. They typically have a lower required rate of return compared to many corporate bonds since investors do not have to pay state or local tax on the income earned from their investments in the municipal bonds. The required rate of return on a bond is the interest rate that a bond issuer must offer in order to get investors interested. If the coupon rate is constant, the value of bond when close to maturity will be a) Issued value b) Par value ANSWER: c) Discount . C) direct D) inverse Answer: C 27) If the required return is less than the coupon rate, a bond will sell at _____. If you've held a bond over a long period of time, you might want to calculate its annual percent return, or the percent return divided by the number of years you've held the investment. About the author. Tweet. Annual yield to maturity equals periodic yield to maturity multiplied by coupon payments per year.eval(ez_write_tag([[300,250],'xplaind_com-large-leaderboard-2','ezslot_14',136,'0','0'])); Where the debt is not publicly traded, the required return on debt can be inferred from the yield to maturity of other marketable bonds which carry the same bond rating as the bond under consideration. Required rate of return > Coupon rate, the bond will be valued at - Published on 14 Sep 15. a. Faisal Wahab. Investors in municipal bonds, or munis, assess the required rate of return based upon the credit rating of the municipality issuing the bonds. When the required rate of return is greater than coupon rate then the discount on the bond declines as the maturity approaches. Related Articles. Click card to see definition ð 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 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 required rate of return is a key concept in corporate finance and equity valuation. The required return for security B = 12.00%. The formula for the general required rate of return can be written as: Required Return = r f + IRP + DRP + LRP + MRP. Access notes and question bank for CFAÂ® Level 1 authored by me at AlphaBetaPrep.com. 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). Copyright 2021 Leaf Group Ltd. / Leaf Group Media, All Rights Reserved. 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. U.S. Treasury bonds, for example, have the full faith and backing of the federal government. A. If the bond is undervalued then the required return is different than the required return. Computing Capital Gains or Losses Note your original purchase price for the bond. The required rate of return is the minimum return an investor expects to achieve by investing in a project. Premium. CAPM: Here is the step by step approach for calculating Required Return. Check You have discovered that when the required rate of return on a bond you own fell by 05 percent from 9.3 percent to 8.8 percent, the fair present value rose from \$965 to \$975. Common Stock). We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Share 0. XPLAIND.com is a free educational website; of students, by students, and for students. Required rate of return > Coupon rate, the bond will be valued at discount. 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. 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. 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. As an example, if â¦ 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 companyâs publicly-traded bonds. the market interest rate. If the company sells its \$1,000 bonds for \$743.50, investors will get that 9 percent return â a 9 percent yield to maturity, in other words. Note that the required return for equity equals 9.3% regardless of whether you use T-bills or government bonds. Long-term bonds have lower interest rate risk. 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. Answers: When the marketâs required rate of return for a particular bond is much less than its coupon rate, the bond is selling at Premium. You are welcome to learn a range of topics from accounting, economics, finance and more. 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 _____. In internal rate of returns, discount rate which forces net present values to become zero is classified as_____? DRP stands for default risk premium, the compensation for risk of investment loss due to default; D. Short-term bonds have higher interest rate risk. 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. Corporate bonds, however, still have a lower required rate of return than stock issued from the same corporation. Corporate credit ratings, as well as bond provisions impacting the investors' rights, both impact perceived risk of the cash flows. 80.408. B. 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. The required rate of return is defined as the return, expressed as a percentage, that an investor needs to receive on an investment to purchase an underlying security. There is an inverse relationship between the bond value and required rate of return i.e. So, bonds issued by the government of other countries have varying levels of risk. principal amount, t is total number of coupon payments till maturity, and r is the periodic yield to maturity. 39. The bond pays interest annually. 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. RRR = 7% or ( (\$3 expected dividend / \$100 per share) + 0.04 growth rate) In the capital asset pricing model (CAPM), RRR can be calculated using the beta of â¦ rf is the real risk-free rate is the rate of return on Treasury inflation-protected securities. Assume annual payments (Do not round intermediate calculations. The bond is â¦ The treasury bond must yield more than 5% per year for the investor to consider taking his money out of the savings account and investing it in the bond. Required Return on Equity (i.e. The strength of that guarantee is what makes them safer than any other type of bond. This is the rate that is added to an investment to adjust it for the marketâs expectation of future inflation. d. None of the above. Round your answer to 1 decimal place. The required rate of return is a function of the marketâs risk-free rate, plus a risk premium specific to the individual issuer. Required Rate of Return Example For example, Joey works for himself as a â¦ Sell the bond in one year when interest rates are 9%. For instance, a \$1,000 bond held over three years with a \$145 return has a 14.5 percent return, but a 4.83 percent annual return. Equity risk premium equals beta multiplied by market risk premium and market risk premium equals the difference between rm and rf. An Inflation Premium . So 9 percent is the required return on the bonds. Rf is the minimum acceptable compensation for the investmentâs level of risk Published 14... An investor expects with zero risk bond return Journal of Housing Research governments around the world differently depending. Example, Joey works for himself as a â¦ Figuring bond return ( r ) over next four is! The compound interest, taxes and fees would have been factored in relationship between the will. Given the risk associated with the bond i.e u.s. Treasury bonds, however, still have a lower required of! 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More information work out required rate of return rate which forces net present values to zero... > Management Accounting ; Q, 2019Studying for CFAÂ® Program step 1 by your total step! Countries have varying levels of risk bank for CFAÂ® level 1 authored by at! Treasury bonds, for example, if â¦ Divide your total from 3... Where, bond will continue paying \$ 100 in interest per year their. Not be determined without more information \$ 1,000 with 10 years to maturity, plus a risk premium market! Also the managing editor of the Journal of Housing Research finance and equity valuation type of bond bonds. Determined by the government of other countries have varying levels of risk in!