S

BONDS AND STOCKS VALUATION

elf-Correction Problems

1. Fast and Loose Company has outstanding an 8 percent, four-year, $1,000-par-value bond on
which interest is paid annually.
a. If the market required rate of return is 15 percent, what is the market value of the bond?
b. What would be its market value if the market required return dropped to 12 percent?
To 8 percent?
c. If the coupon rate were 15 percent instead of 8 percent, what would be the market value [under
Part (a)]? If the required rate of return dropped to 8 percent, what would happen to the market
price of the bond?

2. James Consol Company currently pays a dividend of $1.60 per share on its common stock.
The company expects to increase the dividend at a 20 percent annual rate for the first four years
and at a 13 percent rate for the next four years, and then grow the dividend at a 7 percent rate
thereafter. This phased-growth pattern is in keeping with the expected life cycle of earnings. You
require a 16 percent return to invest in this stock. What value should you place on a share of this
stock?

3. A $1,000-face-value bond has a current market price of $935, an 8 percent coupon rate, and
10 years remaining until maturity. Interest payments are made semiannually. Before you do any
calculations, decide whether the yield to maturity is above or below the coupon rate. Why?
a. What is the implied market-determined semiannual discount rate (i.e., semiannual yield to
maturity) on this bond?
b. Using your answer to Part (a), what is the bond’s (i) (nominal annual) yield to maturity? (ii)
(effective annual) yield to maturity?

4. A zero-coupon, $1,000-par-value bond is currently selling for $312 and matures in exactly 10
years.
a. What is the implied market-determined semiannual discount rate (i.e., semiannual yield to
maturity) on this bond? (Remember, the bond pricing convention in the United States is to use
semiannual compounding – even with a zero-coupon bond.)
b. Using your answer to Part (a), what is the bond’s (i) (nominal annual) yield to maturity? (ii)
(effective annual) yield to maturity?

5. Just today, Acme Rocket, Inc.’s common stock paid a $1 annual dividend per share and had a
closing price of $20. Assume that the market expects this company’s annual dividend to grow at
a constant 6 percent rate forever.
a. Determine the implied yield on this common stock.
b. What is the expected dividend yield?
c. What is the expected capital gains yield?
6. Peking Duct Tape Company has outstanding a $1,000-face-value bond with a 14 percent
coupon rate and 3 years remaining until final maturity. Interest payments are made semiannually.
a. What value should you place on this bond if your nominal annual required rate of
return is (i) 12 percent? (ii) 14 percent? (iii) 16 percent?
b. Assume that we are faced with a bond similar to the one described above, except that
it is a zero-coupon, pure discount bond. What value should you place on this bond if your
nominal annual required rate of return is (i) 12 percent? (ii) 14 percent? (iii) 16 percent?
(Assume semiannual discounting.)

Problems

1. Gonzalez Electric Company has outstanding a 10 percent bond issue with a face value of
$1,000 per bond and three years to maturity. Interest is payable annually. The bonds are
privately held by Suresafe Fire Insurance Company. Suresafe wishes to sell the bonds, and is
negotiating with another party. It estimates that, in current market conditions, the bonds should
provide a (nominal annual) return of 14 percent. What price per bond should Suresafe be able to
realize on the sale?

2. What would be the price per bond in Problem 1 if interest payments were made semiannually?

3. Superior Cement Company has an 8 percent preferred stock issue outstanding, with each share
having a $100 face value. Currently, the yield is 10 percent. What is the market price per share?
If interest rates in general should rise so that the required return becomes 12 percent, what will
happen to the market price per share?

4. The stock of the Health Corporation is currently selling for $20 a share and is expected to pay
a $1 dividend at the end of the year. If you bought the stock now and sold it for $23 after
receiving the dividend, what rate of return would you earn?

5. Delphi Products Corporation currently pays a dividend of $2 per share, and this dividend is
expected to grow at a 15 percent annual rate for three years, and then at a 10 percent rate for the
next three years, a fter which it is expected to grow at a 5 percent rate forever. What value would
you place on the stock if an 18 percent rate of return was required?

6. North Great Timber Company will pay a dividend of $1.50 a share next year. After this,
earnings and dividends are expected to grow at a 9 percent annual rate indefinitely. Investors
currently require a rate of return of 13 percent. The company is considering several business
strategies and wishes to determine the effect of these strategies on the market price per share of
its stock.
a. Continuing the present strategy will result in the expected growth rate and required rate of
return stated above.
b. Expanding timber holdings and sales will increase the expected dividend growth rate to 11
percent but will increase the risk of the company. As a result, the rate of return required by
investors will increase to 16 percent.
c. Integrating into retail stores will increase the dividend growth rate to 10 percent and increase
the required rate of return to 14 percent. From the standpoint of market price per share, which
strategy is best?

7. A share of preferred stock for the Buford Pusser Baseball Bat Company just sold for $100 and
carries an $8 annual dividend.
a. What is the yield on this stock?
b. Now assume that this stock has a call price of $110 in five years, when the company intends to
call the issue. (Note: The preferred stock in this case should not be treated as a perpetual – it will
be bought back in five years for $110.) What is this preferred stock’s yield to call?

8. Wayne’s Steaks, Inc., has a 9 percent, noncallable, $100-par-value preferred stock issue
outstanding. On January 1 the market price per share is $73. Dividends are paid annually on
December 31. If you require a 12 percent annual return on this investment, what is this stock’s
intrinsic value to you (on a per share basis) on January 1?

9. The 9-percent-coupon-rate bonds of the Melbourne Mining Company have exactly 15 years
remaining to maturity. The current market value of one of these $1,000-parvalue, bonds is $700
Interest is paid semiannually. Melanie Gibson places a nominal annual required rate of return of
14 percent on these bonds. What dollar intrinsic value should Melanie place on one of these
bonds (assuming semiannual discounting)?

10. Just today, Fawlty Foods, Inc.’s common stock paid a $1.40 annual dividend per share and
had a closing price of $21. Assume that the market’s required return, or capitalization rate, for
this investment is 12 percent and that dividends are expected to grow at a constant rate forever.
a. Calculate the implied growth rate in dividends.
b. What is the expected dividend yield?
c. What is the expected capital gains yield?

11. The Great Northern Specific Railway has noncallable, perpetual bonds outstanding. When
originally issued, the perpetual bonds sold for $955 per bond; today (January 1) their current
market price is $1,120 per bond. The company pays a semiannual interest payment of $45 per
bond on June 30 and December 31 each year.
a. As of today (January 1), what is the implied semiannual yield on these bonds?
b. Using your answer to Part (a), what is the (nominal annual) yield on these bonds? The
(effective annual) yield on these bonds?

12. Assume that everything stated in Problem 11 remains the same except that the bonds are not
perpetual. Instead, they have a $1,000 par value and mature in 10 years.
a. Determine the implied semiannual yield to maturity (YTM) on these bonds. (Tip: If all you
have to work with are present value tables, you can still determine an approximation of the
semiannual YTM by making use of a trial-and-error procedure coupled with interpolation. In
fact, the answer to Problem 11, Part (a) – rounded to the nearest percent – gives you a good
starting point for a trial-and-error approach.)
b. Using your answer to Part (a), what is the (nominal annual) YTM on these bonds? the
(effective annual) YTM on these bonds?
13. Red Frog Brewery has $1,000-par-value bonds outstanding with the following
characteristics:
currently selling at par; 5 years until final maturity; and a 9 percent coupon rate
(with interest paid semiannually). Interestingly, Old Chicago Brewery has a very similar bond
issue outstanding. In fact, every bond feature is the same as for the Red Frog bonds, except that
Old Chicago’s bonds mature in exactly 15 years. Now, assume that the market’s nominal annual
required rate of return for both bond issues suddenly fell from 9 percent to 8 percent.
a. Which brewery’s bonds would show the greatest price change? Why?
b. At the market’s new, lower required rate of return for these bonds, determine the per bond
price for each brewery’s bonds. Which bond’s price increased the most, and by how much?

14. Burp-Cola Company just finished making an annual dividend payment of $2 per share on its
common stock. Its common stock dividend has been growing at an annual rate of 10 percent.
Kelly Scott requires a 16 percent annual return on this stock. What intrinsic value should Kelly
place on one share of Burp-Cola common stock under the following three situations?

a. Dividends are expected to continue growing at a constant 10 percent annual rate.