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Handout #2 Interest Rates, Bond Valuation, and Stock Valuation Foundations of Finance

Problems on Interest Rates, Bond Valuation and Stock Valuation1

1. A 5-Year Treasury Bond has a 5.2% yield. A 10-year Treasury Bond yields 6.4% and a 10-
year corporate bond yields 8.4%. The market expects that inflation will average 2.5% over
the next 10 years. Assume that, there is no maturity risk premium and that the annual real
risk-free rate of return will remain constant over the next 10 years. A 5year corporate bond
has the same default risk premium and liquidity premium as the 10-year corporate bond.
What is the yield on this 5-year corporate bond?

2. Suppose the inflation rate is expected to be 7% next year, 5% the following year and 3%
thereafter. Assume that the real risk-free rate will remain at 2% and that maturity risk
premiums on treasury securities rise from zero on very short-term bonds (those that mature
in few days) to 0.2% for 1-year securities. Furthermore, maturity risk premiums increase
0.2% for each year to maturity, up to a limit of 1.0% on 5-year or longer T-bonds. Calculate
the interest rate on 1, 2, 3, 4, 5, 10, and 20 year treasury securities.

3. Suppose you are considering two possible investment opportunities: a 12 year Treasury
Bond and a 7-year A-rated corporate bond. The current real risk-free rate is 4% and inflation
is expected to be 2% for the next two years, 3% for the following four years, and 4%
thereafter. The maturity risk premium is estimated by the formula 0.1*(t-1)%. The liquidity
for the corporate bond is estimated to be 0.7% and the default risk premium is 0.9%. What
would be yield for each of these investment opportunities?

4. The following is the treasury yield curve information.

Maturity Yield
1Year 5.37%
2 Years 5.47%
3 Years 5.65%
4 Years 5.71%
5 Years 5.64%
10 Years 5.75%
20 Years 6.33%
30 Years 5.94%

a. Calculate the following

i. 1 year treasury rate 1 year from now

Problems 1 to 9: Source: Fundamentals of Financial Management 12e by Brigham and Houston
Problems 10 to 12: Source: Financial Management: Theory and Practice 7e by Prasanna Chandra

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Handout #2 Interest Rates, Bond Valuation, and Stock Valuation Foundations of Finance

ii. 5 year treasury rate 5 years from now

iii. 10 year treasury rate 10 years from now
iv. 10 year treasury rate 20 years from now.

b. Taking into account the above-presented treasury yield curve information and the
information made available in question 3, calculate the corporate bond yields for 1, 2, 3,
4, 5, 10, 20, and 30 year maturities.

5. Bond X is non-callable and has 20 years to maturity, a 9% annual coupon and $1000 par
value. Your required return on Bond X is 10% and if you buy it, you plan to hold it for 5
years. You and the broader market have expectations that in 5 years, the yield to maturity on
1 15 year bond with similar risk will be 8.5%. How much should you be willing to pay for
Bond X today?

6. You are considering a 10-year, $1000 face value bond. Its coupon rate is 9% and the interest
is paid semi-annually. If you require an effective annual rate of interest of 8.16%, how much
would you be willing to pay for the bond?

7. Last year Joan purchased a $1000 face value corporate bond with an 11% annual coupon
rate and a 10 year maturity. At the time of purchase, it had an expected yield to maturity of
9.79%. If Joan sold the bond today for $1060.49, what rate of return would she have earned
for the past year?

8. Kaufman Enterprises has bonds outstanding with a face value of $1000 and 10 years left
until maturity. They have an 11% annual coupon payment and their current price is $ 1,175

a. The bonds may be completely called in 5 years at 109% of face value. If so, what is
the yield to maturity and what is the yield to call if the bond was called completely at
the end of 5 years?
b. Suppose the bonds indenture contains a call provision that gives the firm the right
to call the bonds anytime on or after 5 years until the date of maturity of bond
subject to the following conditions. IN year 5, the bond may be called at 109% of
face value, but in each of the next four years, the call percentage will decline by 1%.
Thus in year 6, the bonds may be called y the company at 108% of face value; in year
7 the bonds may be called at 107% of face value and so forth. If the yield curve is
horizontal and the interest rates remain at the current level, when is the latest that
investors might expect the firm to call bonds?

9. Clifford Cark is a recent retiree who is interested in investing some of his savings in
corporate bonds. His financial planner has suggested the following three bonds
Bond A: 7% annual coupon, time to maturity 12 years; face value = $ 1000

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Handout #2 Interest Rates, Bond Valuation, and Stock Valuation Foundations of Finance

Bond B: 9% annual coupon, time to maturity 12 years; face value: $ 1000

Bond C: 11% annual coupon, time to maturity 12 years; face value $ 1000
Each bond has a yield to maturity of 9%.

I. Calculate the price of bonds A, B, and C.

II. Calculate the current yield for each of three bonds
III. If YTM remains at 9%, what will be the price of each of the bonds one
year from now? Also, what will be expected capital gains yield and total
expected return for each of the bonds?

Mr. Clark is considering another Bond D, which has an 8% coupon paid on a semi-annual
basis, and a face value of $ 1000. Bond D is scheduled to mature in 9 years and has a price of
$ 1,150. It is callable in 5 years at a call price of $ 1040.

IV. What is Bond Ds nominal YTM?

V. What is Bond Ds nominal YTC?
VI. Calculate the price of bonds A, B, and C at the end of each until
maturity, assuming a flat yield curve.

10. The share of a certain stock paid a dividend of Rs. 2 last year (D0=2.00). The dividend is
expected to grow at a constant rate of 6% in the future. The required rate of return on this
stock is considered to be 12%. How much should this stock sell for now? Assuming that the
expected growth rate and the required rate of return remains the same, at what price should
the stock sell 2 years hence?

11. Zenith Electronics paid a dividend of Rs. 10 per share yesterday (D0=10.00). Zenith
Electronics is expected to grow at a supernormal growth rate of 25% for the next four years,
before returning to a constant growth rate of 10% thereafter. What will be the present value
of the stock, if the investors require a return of 16%?

12. The earnings and dividends of Ravi Pharma are expected to grow at a rate of 20% for the
next three years. Thereafter, the growth rate is expected to decline linearly for the following
5 years before settling down at 10% per year forever. Ravi Pharma paid a dividend of 8% per
share yesterday (D0=8.00). If investors require a return of 14% from the equity of Ravi
Pharma, what is the intrinsic value per share?

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