Running head: INDIVIDUAL ASSIGNMENT

Text Problem Sets Gianeris Rivera-Marquez FIN 571 May 30, 2011 Prof. Walter A. Foggie

INDIVIDUAL ASSIGNMENT
Text Problems 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? Calculating PV factor: i= required return = 9% = 0.09 n= 10 years Using Cash Flow of $1000 to calculate present value, Cash flow= $1000 PV factor = 1/(1+i)^n = 0.42241 PV = $1000*0.42241= 422.41 Using Coupon Rate to calculate present value of Annuity Cash flow= $1000 * 7.4/100 = $74 PV factor = (1/i)*(1- 1/(1+i)^n) = 6.4176 So, PV = $74*6.4176 = 474.90| So the fair value of 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/(10%-6%) = $140 A12. (Required return for a preferred stock) James River $3.38 preferred is selling for $45.25. The preferred dividends is now growing. What is the required return on James River preferred stock? Required Return = Dividend/Market Price

INDIVIDUAL ASSIGNMENT Dividend = $3.38 Market Price = $45.25 Required Return = $3.38 / $45.25 Required Return = 7.47%

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 quarterly). What is the stock worth? Perpetual Quarterly Preferred Dividend (D) = $1.00 Annual Dividend ($1.00 x 4.00) = $4.00 Annual Percentage Rate (APR) = 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 Year Maturity n=1x2=2 r = 8% / 2 = 4% PV = ? PMT = 9.125% x 1,000 / 2 = $45.62 FV = $1,000 PV = -$1,010.61 7 Year Maturity

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n = 7 x 2 = 14 r = 8% / 2 = 4% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,059.42 15 Year Maturity n = 15 x 2 = 30 r = 8% / 2 = 4% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,097.27 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? 1Year Maturity n=1x2=2 r = 7% / 2 = 3.5% PV = n/a PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,020.18 7 Year Maturity

INDIVIDUAL ASSIGNMENT n = 7 x 2 = 14 r = 7% / 2 = 3.5% PV = n/a PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,116.03 15 Year Maturity n = 15 x 2 = 30 r = 7% / 2 = 3.5% PV = n/a PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,195.42 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 Year Maturity n=1x2=2 r = 9% / 2 = 4.5% PV = n/a PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,001.17 7 Year Maturity n = 7 x 2 = 14

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r = 9% / 2 = 4.5% PV = n/a PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,006.39 15 Year Maturity n = 15 x 2 = 30 r = 9% / 2 = 4.5% PV = n/a PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,010.18 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? Calculating Realized Return on Investment Rate: Present Value of the Bond $500.00 Par Value of the Bond $1,000 Annual Coupon Rate 9.50% Number of years to Maturity =3.5 Present Value of the Bond (PV) =500.00 Future Value (Parvalue of the Bond ) (FV) = -1,000

INDIVIDUAL ASSIGNMENT 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? Calculating Realized Return on Investment Rate: Present Value of the Bond = $500.00 Par Value of the Bond = $1,000 Annual Coupon Rate = 9.50% Number of years to Maturity =10 Annual Coupon Payment (PMT) ($1000 * 9.50%) =-95 Present Value of the Bond (PV) =500.00 Future Value (or) Parvalue of the Bond (FV) =-1,000 Realized Rate of Return on Investment (Rate) =0.2242 Realized Return on Investment (Rate) =22.42% 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 in 2 years (D2) = $1.00 Dividend growth rate (g) = 6% Required Rate of Return (R ) = 13% Medtrans Stock Value (P2) = D3 / (R - g) (P2) = D2 (1+g) / (0.13 - 0.06) (P2) = $1.00 (1.06) / 0.07

INDIVIDUAL ASSIGNMENT (P2) = $1.06 / 0.07 = $15.14 b. What value would Bret assign to the Medtrans stock? Medtrans 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 = $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. a. Calculate the expected returns on the stock market and on Chicago Gear stock. Stock Market rM = Prob1*rM1 + Prob2*rM2 + Prob3*rM3 + Prob4*rM4 = 0.2(-10%) + 0.35(10%) + 0.3(15%) + 0.15(25%) = 9.75%. Chicago Gear Project rCG = Prob1*rCG1 + Prob2*rCG2 + Prob3*rCG3 + Prob4*rCG4 = 0.2(-15%) + 0.35(15%) + 0.3(25%) + 0.15(35%) = 15.0%. 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%.

INDIVIDUAL ASSIGNMENT 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%. Calculate beta CG = 1.80%/1.2119% = 1.49. c. What is Chicago Gears required return according to the CAPM? rCG = rf + BCG(rM - rf) = 6% + 1.49(9.75% - 6%) = 11.59%.

References Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate Financial Management (3rd ed.). Upper Saddle River, NJ: Prentice Hall.

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