Question

Assume that IBM starts selling common stock and bonds today. The rate of return on bonds is 10%.

a. on average, we expect the rate of return on common stock to be equal to 10%

b. on average, we expect the rate of return on common stock to be greater than 10%

c. on average, we expect the rate of return on common stock to be less than 10%

d. on average, we do not know what to except because it depends on the risk of the firm

e. on average, we do not know what to expect because we do not know the risk and return relationship

Would this answer be (D)? The risk and return relationship are positive, so I’m assuming if we don’t know the risk of the investment. I cannot know what to expect.

Answer 1

The risk associated with an investment in equity is always higher than the investment in a company's bonds. Bond holder of the company are paid before any payment is made to shareholders in the form of dividend. Also, in case of liquidation, the bondholders have a claim over the assets of the firm before shareholders. Hence, as shareholders have a higher risk, they should receive higher return as compensation.

Therefore, assuming that IBM starts selling common stocks and bonds today. The rate of return on bonds is 10%.

B. On average, we expect the rate of return on common stock to be greater than 10%.

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