Risk Discount

Question

4. An investor is valuing the shares and bonds of AwesomeCompany. She is valuing

the shares at an interest rate of 9.25% and the bonds at an interest rate of 7% p.a.

(i) State two reasons why shares are considered more risky than bonds. (2)

(ii) When the investor is valuing AwesomeCompany shares:

A the risk free rate is 7% and the risk premium is 2.25%

B the risk free rate is more than 7% and the risk premium is less than 2.25%

C the risk free rate is less than 7% and the risk premium is more than 2.25%

D the risk free rate is less than 7% and the risk premium is less than 2.25%

E the risk free rate is more than 7% and the risk premium is more than 2.25%

F None of the above

For 4(ii), please may someone explain why the answer is C?

Comments

Awe. 

Well the reason we assume that shares are more risky than bonds is because we believe that the resturn on the bond is predetermined and usually backed. This means that we expect to receive regular coupons payments from the borrower and we expect a future redemption payment. With shares, on the other hand, we are not guaranteed anything (except perhaps the actual share whose future value is uncertain). Yes we could have a share that increases in value and that persuades the company to pay dividends but the share could also lose value causing the company to go bankrupt (extreme examples). The main thing is that we just don’t know how things will go when it comes to shares. Whereas we can have a lot more confidence in how things will go when it comes to bonds. 

The reason the second question is C is because we expect the risk free rate of return to be the return we would get on government bonds (treasury bills). This is because this type of asset is the safest monetary asset we can attain. Although I’ve said above that we can have confidence in the corporate bond, there is still risk attached to it. Like the risk of the company going insolvent   Because of that, we attach a small risk premium to its rate of return (we require a higher rate of return on the asset in compensation for the extra risk we are taking on). The risk premium on the shares must, therefore, be higher than 2.5% if we have to get 9.5% and we subtract a risk free rate that is lower than 7% (let’s say 6%) then you can see how the result is going to be higher than 2.5% (in this case it would be 3.5%). 

Answer 1

My understanding would be (although I speak under correction) that, although bonds are less risky than shares, they are still risky. Bonds can be defaulted on if absolutely necessary. Hence, bonds should also have a risk premium, just a much smaller one than on shares. 

So the risk-free rate is less than 7%, and the risk premium on the shares must therefore be greater than 2.5%.

Answer 2

Note that both the bond and the share are issued by the company. The risk free rate is generally given by the rate given by government bonds (as theoretically their is no chance of default). The company on the other hand, can default and thus not be able to pay the bond holder their given interest. Consequently we would add a risk premium onto the risk free rate for a company bond and share.

Now we know that the risk free rate is less than 7% (because a company can default on the bond payments), thus the risk premium on the share must be greater than 2.25%. Thus you get the answer c.