CH5.5.

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 whether each statement is true or false.

Statements	True	False
Interest rates affect the level of economic activity, which in turn affects the profits earned by a business organization, all other considerations remaining constant.
Interest rates will affect the preference of investors to own stocks versus owning bonds.
A sharp decrease in interest rates will increase the price of bonds, which can significantly decrease the potential for capital gains and the yield earned by a bondholder. This should decrease the demand for bonds compared to the demand for stocks, all other considerations remaining constant.
An increase in market interest rates will increase the opportunity cost of investors funds and increase the price of financial assets.

To further examine the relationship between interest rates and the price of financial assets, consider the effect of a change in an investors required return, or opportunity cost, on the price of a financial asset.

Four years ago, Becky purchased a perpetuity that agrees to pay her and her heirs $150 per month forever. At the time of purchase, Becky was expecting to earn an annual return of 6.00%, but in the intervening years, the economy and the available investment alternatives have changed. In todays market, it is now reasonable to anticipate an annual return of 3.60%.

By how much would you expect the value of Beckys perpetuity to change from when she purchased it until today?

$30,000

$1,667

$50,000

$20,000