We used the DCF Model (r(D/Po)+g) to estimate the required rate of return on com

Question

We used the DCF Model (r(D/Po)+g) to estimate the required rate of return on common equity Which of the following assumptions does the model include? Select one a. Growth is assumed to be constant to infinity Ob. The required rate of return must exceed the assumed growth rate O c. The firm must pay a dividend to use this mode d. Two of the above are assumptions of the model O e. All of three are assumptions of the model A firm is about to raise debt capital with a new bond issue. They could issue a 10-year bond with a 5% annual coupon with no special features or covenants. Alternatively, they could issue a 10-year bond that is convertible into common equity and has several restrictive covenants. Which of the following most accurately describes the coupon rate on the convertible bond? Select one O a. It could be more or less than 5%. b there's no way to estimate the likely coupon rate c it will likely be exactly equal to 596. d O it will likely be less than 596 9:03 PM a do 6/13/2018

Explanation / Answer

QUESTION 1. Option e is correct

By constant growth dividend discount model, V0 = D1/(r - g) {Same equation as given in question, just reframed it)

For constant growth dividend discount model, growth is assumed to be constant till infinity. Also, if you see the denominator here, it is r - g, which assumes that rate of return must always be higher than growth rate. If in case it becomes less, then the value of share would be negative, which is not possible. Also, this model is based on dividends paid by company and hence, in order to apply this model, it becomes a prime requirement for company to pay dividend.

QUESTION 2. Option e is correct

A convertible bond has an embedded option with it, for the investor, to have it get converted into equity. An embedded option for investor, implies greater value for investor. So, for a bond with convertibility option and without convertibility option, former would be priced higher. Higher price implies lower yield/coupon. Hence, the option e. Convertible bonds are low cost funding option for companies.

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