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# Week 2 Problem Sets Noneya Bizness FIN/571 Corporate Finance Monday, July 25, 2011 Professor Terry Loserton

## Week 2 Problem Sets

Chapter 5 A1.

(Bond valuation) A \$1,000 face value bond has a remaining maturity of 10 years and a required return of 9%. The bonds coupon rate is 7.4%. What is the fair value of this bond? PV factor calculation: I is return required (9%) = 0.09 N is the period of maturity = 10 Bond Value is \$1000 (Cash flow) PV Factor = 1/(1+I)^N = 0.42241 PV = 1000 * 0.42241 = 422.41 Coupon rate is used to calculate the present value of the bond. Cash flow = \$1000 * 7.4/100 = \$74 PV factor = (1/I) * (1-1/(1+I)^N = 6.4176 PV = \$74 * 6.4176 = 474.90 Fair Value of the bond = 474.90 + 422.41 = 897.31

A10.

(Dividend discount model) Assume RHM is expected to pay a total cash dividend of \$5.60 next year and its dividends are expected to grow at a rate of 6% per year forever. Assuming annual dividend payments, what is the current market value of a share of RHM stock if the required return on RHM common stock is 10%? Current market value = D1/(Required return growth rate) = 5.60 / (0.10 0.06) = 5.60 / (0.04) = \$140

A12.

(Required return for a preferred stock) James River \$3.38 preferred is selling for \$45.25. The preferred dividend is nongrowing. What is the required return on James River preferred stock? Required return = Dividend / Market Price Dividend = \$3.38 Market Price = \$45.25 Required return = 3.38 / 45.25 Required return = 7.47%

## Week 2 Problem Sets

A14.

(Stock valuation) Suppose Toyota has nonmaturing (perpetual) preferred stock outstanding that pays a \$1.00 quarterly dividend and has a required return of 12% APR (3% per quarter). What is the stock worth? Perpetual Qtrly. Preferred Dividend (D) = \$1.00 Annual Dividend = (1.00 * 4) = \$4.00 Annual Percentage Rate (APR) = 12% or .12 Preferred Stock Value (P0) = (D / R) P0 = (4.00 / 0.12) P0 = \$33.33

B16.

(Interest-rate risk) Philadelphia Electric has many bonds trading on the New York Stock Exchange. Suppose PhilEls bonds have identical coupon rates of 9.125% but that one issue matures in 1 year, one in 7 years, and the third in 15 years. Assume that a coupon payment was made yesterday. a. If the yield to maturity for all three bonds is 8%, what is the fair price of each bond? 1 yr maturity n=1x2=2 r = 8% / 2 = 4% PV = x PMT = 9.125% x 1000 / 2 PMT = 91.25 / 2 = 45.625 FV = \$1000 PV = \$1010.61 7 yr maturity n = 7 x 2 = 14 r = 8% / 2 = 4% PV = x PMT = 9.125% x 1000 / 2 = 45.625 FV = \$1000 PV = \$1059.42 15 yr maturity n = 15 x 2 = 30 r = 8% / 2 = 4% PV = x PMT = 9.125% x 1000 / 2 = 45.625 FV = \$1000 PV = (\$1097.27)

## Week 2 Problem Sets

b. Suppose that the yield to maturity for all of these bonds changed instantaneously to 7%. What is the fair price of each bond now? 1 yr maturity n=1x2=2 r = 7% / 2 = 3.5% PV = x PMT = 9.125% x 1000 / 2 PMT = 91.25 / 2 = 45.625 FV = \$1000 PV = \$1020.18 7 yr maturity n = 7 x 2 = 14 r = 7% / 2 = 3.5% PV = x PMT = 9.125% x 1000 / 2 PMT = 91.25 / 2 = 45.625 FV = \$1000 PV = \$1116.03 15 yr maturity n = 15 x 2 = 30 r = 7% / 2 = 3.5% PV = x PMT = 9.125% x 1000 / 2 PMT = 91.25 / 2 = 45.625 FV = \$1000 PV = \$1195.42 c. Suppose that the yield to maturity for all of these bonds changed instantaneously again, this time to 9%. Now what is the fair price of each bond?

1 yr maturity n=1x2=2 r = 9% / 2 = 4.5% PV = x PMT = 9.125% x 1000 / 2 PMT = 91.25 / 2 = 45.625 FV = \$1000 PV = \$1001.17 7 yr maturity n=1x2=2 r = 9% / 2 = 4.5% PV = x PMT = 9.125% x 1000 / 2 PMT = 91.25 / 2 = 45.625 FV = \$1000 PV = \$1006.39 15 yr maturity n=1x2=2 r = 9% / 2 = 4.5% PV = x PMT = 9.125% x 1000 / 2

## Week 2 Problem Sets

PMT = 91.25 / 2 = 45.625 FV = \$1000 PV = \$1010.18

d. Based on the fair prices at the various yields to maturity, is interest-rate risk the same, higher, or lower for longer- versus shorter-maturity bonds? It appears from my calculations that the interest-rate risk is lower when the actual interest rater is lower. The PV also grows a bit as the length of time is increased. B18. (Default risk) You buy a very risky bond that promises a 9.5% coupon and return of the \$1,000 principal in 10 years. You pay only \$500 for the bond. a. You receive the coupon payments for three years and the bond defaults. After liquidating the firm, the bondholders receive a distribution of \$150 per bond at the end of 3.5 years. What is the realized return on your investment? The calculation for realized return on investment rate is: PV of bond = \$500 Par Value of bond = -1000 Annual coupon rate = 9.50% Num of yrs to mature = 3.5 PV = 500 FV = -1000 Realized return on investment (Rate) = 37.34% b. The firm does far better than expected and bondholders receive all of the promised interest and principal payments. What is the realized return on your investment? Realized return on investment rate is calculated: PV of bond = \$500 Par value of bond = \$1000 Annual coupon rate = 9.50% Num of yrs to mature = 10 Annual coupon payment = (1000 * .095) = 95 PV of bond = 500 FV or Par value of bond = -1000 Realized rate of return on investment = 0.2242 Realized rate of return on investment = 22.42%

## Week 2 Problem Sets

B20.

(Constant growth model) Medtrans is a profitable firm that is not paying a dividend on its common stock. James Weber, an analyst for A. G. Edwards, believes that Medtrans will begin paying a \$1.00 per share dividend in two years and that the dividend will increase 6% annually thereafter. Bret Kimes, one of James colleagues at the same firm, is less optimistic. Bret thinks that Medtrans will begin paying a dividend in four years, that the dividend will be \$1.00, and that it will grow at 4% annually. James and Bret agree that the required return for Medtrans is 13%. a. What value would James estimate for this firm? Dividend paid out in 2 years (D2) = \$1000 Dividend growth rate (g) = 6% or .06 Required rate of return (R) = 13% or .13 Stock value (P2) = D3 / (R g) P2 = D2 ( 1 + g) / (0.13 0.06) P2 = \$1.00 (1.06) / 0.07 P2 = \$1.06 / 0.07 Stock value for MedTrans per James Weber: \$15.14 b. What value would Bret assign to the Medtrans stock? Stock value (P4) = D5 / (R g) P4 = D5 (1 + g) / (0.13 0.04) P4 = \$1.00 (\$1.04) / 0.09 P4 = \$1.04 / 0.09 Stock value for MedTrans per Bret Kimes: \$11.55

Chapter 7 C1. (Beta and required return) The riskless return is currently 6%, and Chicago Gear has estimated the contingent returns given here. REALIZED RETURN State of the Market Stagnant Slow growth Average growth Rapid growth Probability that State Occurs 0.20 0.35 0.30 0.15 Stock Market (10%) 10 15 25 Chicago Gear (15%) 15 25 35

a. Calculate the expected returns on the stock market and on Chicago Gear stock. rM = Prob1 * rM1 + Prob2 * rM2 + Prob3 * rM3 + Prob4 * rM4 rM = 0.2(-10%) + 0.35(10%) + 0.3(15%) + 0.15(25%) rM = 9.75% rCG = Prob1 * rCG1 + Prob2 * rCG2 + Prob3 * rCG3 + Prob4 * rCG4 rCG = 0.2(-15%) + .35(15%) + 0.3(25%) + 0.15(35%) rCG = 15%

## Week 2 Problem Sets

b. What is Chicago Gears beta? COV(CG,M) = 0.2(-10-9.75)(-15 15) + 0.35(10%-9.75%)(15%-15%) + 0.3(15%-9.75%)(25%15%) + 0.15(25%-9.75%)(35%-15%) = 1.80% VAR(M) = 0.2(-10%-9.75%)2 + 0.35(10%-9.75%)2 + 0.3(15%-9.75%)2 + 0.15(25%-9.75%)2 = 1.2119% To calculate the beta: CG = 1.80% / 1.2119 CG = 1.49 c. What is Chicago Gears required return according to the CAPM? rCG = rf + BCG(rM rf) rCG = 6% + 1.49(9.75%-6%) rCG = 11.59%