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1) Sir when we say that debt prices falls as interest rates rises , so basically we mean to say that due to increase in interest rates, cost of debt increases leading to decrease in market value of debt. Right?
2) Debt is cheap. Since it is less risky than equity for investor, loan notes holders will accept lower rate of return than shareholders. Here equity means only ordinary shares or does it mean both ordinary shares and preference shares?
3) Is cost of equity and return on equity the same thing?
4) Is cost of equity and return on equity predicted by CAPM the same thing?
1. Yes, although it would be better to say that due to the increase in interest rates, the investors required return increases (it is the investors required rate of return that determines the market value).
2. Equity only ever means ordinary shares. As far as preference shares are concerned, because they carry a fixed dividend they are less risk than equity, but a bit more risky than debt.
3. Normally yes (but watch the wording in the exam – sometimes they just want the return over one year).
4. Yes (assuming CAPM is working perfectly – it doesn’t always work perfectly in real life).
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