Solutions to problems of TUTORIAL 4 (Valuation of Stocks and Bonds) 1.

A Rs 100 par value bond bearing a coupon rate of 12 % will mature after 5 years. What is the value of the bond, if the discount rate is 15 % ? [Ans: Rs 89.92] 2. The market price of a Rs 1,000 par value bond carrying a coupon rate of 14 % and maturing after 5 years is Rs 1,050. What is the yield to maturity on this bond ? What is the approximate YTM ? What will be the realized YTM if the re-investment rate is 12 % ? [Ans: 12.60 %, 12.62 %, 12.89 %] 3. A Rs 100 par value bond bears a coupon rate of 14 % and matures after 5 years. Interest is payable semi-annually. Compute the value of the bond of the required rate of return is 16 %. [Ans: Rs 93.27] 4. Verbrugge Company has a level-coupon bond outstanding that pays coupon interest of $120 per year and has 10 years to maturity. The face value of the bond is $1,000. If the yield for similar bonds is currently 14%, what is the bond's current market value? [Ans: $ 895.68] Solution:
PV = [$120 PVIFA(14%,10)] + $1,000 (1.14)10 = ($120 5.2161) + ($1,000 .26974) = $895.68. The bond is selling at a discount because the yield (the market's required return) is greater than the coupon rate.

5. For the Verbrugge Company bond described in Problem 7, find the bond's value if the yield for similar bonds decreases to 12%. [Ans: $ 1,000] Solution
PV = [$120 PVIFA(12%,10)] + $1,000 (1.12)10 = ($120 5.6502) + ($1,000 .3219) = $1,000. The bond is selling at par because the coupon rate is the same as the market's required return.

6. For the Verbrugge Company bond described in Problem 7, find the bond's value if the yield for similar bonds decreases to 9%. [Ans: 1192.53] Solution:
PV = [$120 PVIFA(9%,10)] + $1,000 (1.09)10 = ($120 6.4176) + ($1000 .4224) = $1,192.53. Now the bond is a premium bond, because the bond's yield is less than its coupon rate.

7. What conclusions can you draw out of the solutions of the problems 7,8 and 9 ? 8. Suppose the Verbrugge bond paid interest semiannually. What would its value be if the yield is 14%? [Ans: $ 894.06] Solution:
Coupon payments are now $60 per period for 20 time periods; the relevant discount rate is 7%. PV = [$60 PVIFA(7%,20)] + $1,000 (1.07) 20 = ($60 10.5940) + ($1,000 .2584) = $894.06. Notice that this value differs somewhat from the result obtained in Problem 1; this difference results from the assumption of annual interest payments in the earlier problem.

9. Sasha Company has a level-coupon bond with a 9% coupon rate; interest is paid annually. The bond has 20 years to maturity and a face value of $1,000; similar bonds currently yield 7%. By prior agreement the company will skip the coupon interest payments in years 8, 9, and 10. These payments will be repaid, without interest, at maturity. What is the bond's value? [Ans: $ 1134.56] Solution:

To be submitted on 31st October

This problem can be solved by calculating the PV of each coupon interest payment, plus the PV of the face value. However, an easier approach is to first calculate the PV of the bond under the assumption that all the coupon interest is paid; then deduct the PV of the payments that are skipped and add the PV of the payments made at maturity. The bond's value, ignoring skipped and repaid coupons, is $1,211.88. The PV of skipped coupons is: PV = $90/(1.07)8 + $90/(1.07)9 + $90/(1.07)10 = $147.09. At maturity, an extra (3 $90) = $270 will be paid. The PV of this $270 is $69.77. Thus the value of the bond is ($1,211.88 - $147.09 + $69.77) = $1,134.56.

10. A firm issues a bond today with a $1,000 face value, an 8% coupon interest rate, and 25-year maturity. An investor purchases the bond for $1,000. What is the yield to maturity (YTM)? [Ans: 8%] Solution:
The yield to maturity is 8%; that is, when r = .08, the PV of the future payments is exactly $1,000. However, this problem can be solved directly by realizing that the $80 coupon interest payment is 8% of the face value of the bond. The result is true regardless of the time period: an investor who buys a bond for its $1,000 face value earns a yield to maturity equal to the coupon interest rate.

11. Suppose the investor bought the bond described in the previous problem for $900. What is the YTM? [Ans: 9.0197] 12. Suppose the bond described in the previous two problems has a price of $1,100 five years after it is issued. What is the YTM at that time? [Ans: 7.0522] 13. If the real rate is 4% and the inflation rate is 10%, what is the nominal return for a one-year Tbill? [Ans: 14.4 %] Solution:
R = 1.04 1.10 - 1 = 1.144 - 1= .144 = 14.4%.

14. If the one-year T-bill rate is 8% and the expected inflation rate is 3% during the next year, what real rate of return does the investor expect? [Ans: 4.854] Solution:
The real rate of return, r, equals .04854 = 4.854%.

15. Suppose the investor described in the previous problem purchases the one-year T-bill, then finds that after one year, the actual inflation rate was 10%. What real return did the investor earn during the year? [Ans: investor has lost almost 2% on the Treasury bill investment] Solution:
The real return is determined by substituting R=.08 and h=.10 in the following equation: 1 + r = (1 + R)/(1 + h) = 1.08/1.10 = .98182 Therefore, r = .98182 -1 = -.01818 = -1.818%. In real terms, the investor has lost almost 2% on the Treasury bill investment because the inflation rate was higher than the nominal rate of return.

16. The equity stock of Rax Limited is currently selling for Rs 30 per share. The dividend expected next year is Rs 2.00. The investors required rate of return on this stock is 15 %. If the constant growth model applies to Rax Limited, what is the expected growth rate ? [Ans: 8.3 %] To be submitted on 31st October 2

17. XYZ limiteds earnings and dividends have been growing at a rate of 18 % per annum. This growth rate is expected to continue for 4 years. After that the growth rate will fall to 12 % for the next 4 years. Thereafter, the growth rate is expected to be 6 % forever. If the last dividend per share was Rs 2.00 and the investors required rate of return on XYZs equity is 15 %, what is the intrinsic value per share? [Ans: Rs 40.32] 18. The current dividend on an equity share of Pioneer Technology is Rs 3.00. Pioneer is expected to enjoy an above-normal growth rate of 40 % for 5 years. Thereafter, the growth rate will fall and stabilize at 12%. Equity investors require a return of 18% from Pioneers stock. What is the intrinsic value of the equity share of Pioneer? [Ans: Rs 327.49] 19. A security analyst has forecast the dividends of Hodges Enterprises for the next three years. His forecast is: D1 = $1.50; D2 = $1.75; D3 = $2.20. He has also forecast a price in three years of $48.50. The rate of return for similar-risk common stock is 14%. What is the value of Hodges common stock? [Ans: 36.88] Solution:
P0 = PV = $1.50/(1.14)1 + $1.75/(1.14)2 + $2.20/(1.14)3 + $48.50/(1.14)3 = $36.88

20. TTK Corp. preferred stock pays a $10 annual dividend per share. What is the price of a share of TTK preferred if similar-risk preferred yields 8%? If the price of comparable preferred yields 11%? [Ans: $ 90.91] Solution:
P0 = PV = D/r = $10/.08 = $125. If the opportunity cost is 11%, then P0 = ($10/.11) = $90.91

21. A share of preferred stock with a $12 annual dividend is selling for $75. What is the required rate of return for the preferred stock? [Ans: 16 %] Solution:
Since D = $12 and P0 = $75, and P0 = D/r; $75 = $12/r. Therefore, r = .16 = 16%.

22. Hilliard, Inc., just paid a $2 annual dividend on its common stock. The dividend is expected to increase at 8% per year indefinitely. If the required rate of return is 16%, what is the stock's value? [Ans: $ 27.00] Solution:
Hilliard is a constant growth stock with D0 = $2.00. D1 = $2.00 1.08 = $2.16, so P0 = PV = D1/(r - g) = $2.16/(.16 - .08) = $27.00.

23. The dividend paid this year (D0) on a share of common stock is $10. If dividends grow at a 5% rate for the foreseeable future, and the required return is 10%, what is the value of the stock today? Last year (date t = -1)? Next year (date t = 1)? [Ans: $ 210 , 200, 220.50] Solution:
P0 = D1/(r - g) = [$10(1.05)]/(.10 - .05) = $210. P-1 = D0/(r - g) = $10/(.10 - .05) = $200 P1 = D2/(r - g) = [$10(1.05)2]/(r - g) = $220.50

To be submitted on 31st October

24. The current price of a stock (P0) is $20 and last year's price (P-1) was $18.87. The latest dividend (D0) is $2. Assume a constant growth rate (g) in dividends and stock price. What is the stock's return for the coming year? [Ans: 16.6 %] Solution:
Since r = D1/P0 + g, and P0 = $20, we can determine the values of g and D1. The growth rate for dividends is the same as that for the stock price. Solve for g: P0 = P-1 (1 + g) $20 = $18.87 (1 + g) (1 + g) = $20/$18.87 = 1.05988 Therefore, g is approximately 6%. Applying the growth rate to dividends, D1 = $2 1.06 = $2.12. Substituting these values into the above equation for r, we find that r = .166 = 16.6%.

25. The current year's dividend (D0) for a share of common stock is $2 and the current price (P 0) of the stock is $30. Dividends are expected to grow at 5% forever. What is the rate of return for this stock? [Ans: 12 %] Solution:
Substitute P0 = $30, D0 = $2, g = .05 into the following equation and solve for r: P0 = D1/(r - g) = [$2(1.05)]/(r - .05) = $30. The rate of return, r, equals .12 = 12%.

26. Pettway Corporation's next annual dividend (D1) is expected to be $4. The growth rate in dividends over the following three years is forecasted at 15%. After that, Pettway's growth rate is expected to equal the industry average of 5%. If the required return is 18%, what is the current value of the stock? [Ans: $ 38.39] Solution:
P0 equals the PV of the dividends from the high-growth phase, plus the PV of the stock price when that phase ends. The next dividend (D1) is forecasted at $4. To calculate the stock price at year 4, we first determine the year 5 dividend (D5): D5 = D1 (1.15)3 (1.05) = $6.39. So P4 = D5/(r - g) = $6.39/(.18 - .05) = $49.16. The PV of this is [$49.16/(1.184)] = $25.36. The PVs of the first four dividends are: Year Growth Rate (g) Expected Dividend Present Value 1 2 3 4 15% 15% 15% 15% $4.000 $4.600 $5.290 $6.084 $3.3898 $3.3036 $3.2197 $3.1381

To be submitted on 31st October

The total PV of the first four dividend payments is $13.0512. P0 is ($25.34 + $13.05) = $38.39.

27. A company pays a current dividend (D0) of $1.20 per share on its common stock. The annual dividend will increase by 3%, 4% and 5%, respectively, over the next three years, and by 6% per year thereafter. The appropriate discount rate is 12%. What is P0? [Ans: $ 20.08] Solution:
D1 = $1.20 (1.03) = $1.24 D2 = $1.20 (1.03) (1.04) = $1.29 D3 = $1.20 (1.03) (1.04) (1.05) = $1.35 P3 = D4/(r - g) = [$1.35(1.06)]/(.12 - .06) = $23.83 The current price (P0) is the PV of the next three year's dividends plus the PV of P3, discounted at 12%. The PV of the former is $3.10; the PV of the latter is $16.98. Therefore, P0 is $20.08.

To be submitted on 31st October