Interest rates affect corporate profits and security prices. Based on your under

Question

Interest rates affect corporate profits and security prices. Based on your understanding of the relationship between interest rates and corporate profits and security prices, identify which of the following statements is true and which is false. To further examine the relationship between interest rates and the price of financial assets, consider the effect of a change in an investor's required return, or opportunity cost, on the price of a financial asset. Five years ago, Alejandro purchased a perpetuity that agrees to pay him and his heirs S300 per month forever. At the time of purchase, Alejandro was expecting to earn an annual return of 7.00%, but in the intervening years, the economy and the available investment alternatives have changed. In today's market, it is now reasonable to anticipate an annual return of 4.25%. By how much would you expect the value of Alejandro's perpetuity to change from when he purchased it until today? 584,705 52,773 551,429 533,276

Explanation / Answer

Solution 1

Statement 1: False

Paying higher price actually reduces the rate of return for the investors. If they pay a lower price and price increases when the stock is sold, then they get higher returns.

Statement 2: True

Lowering interest rate helps the firm in paying lower interest and this eventually increases the profit of the firm. So the firm now, can pay the interest and principal amount and if there any residual profit left, it can use it to pay dividend to stockholders.

Statement 3: False

Interest is a charge on profit. So as interest rate increases, profit decreases and as interest rate decreases, profit increases.

Statement 4: True

Present value and required return share inverse relationship. That is when required return increases, present value decreases and vice versa.

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