Problem Set 4
Due Tuesday, March 3rd
Part 1: Bonds
1. Compute the yield to maturity for a bond with
• a face value of $5000,
• an annual coupon rate of 5%,
• coupons paid semi-annually,
• a maturity of two years,
when the price of the bond today is (a) $5250, (b) $5000, and (c) $4750. Report the
yield to maturity as an APR.
2. Assume you hold a 10-year bond with face value $1000 that pays annual coupons at
a rate of 3%. The current yield to maturity is 2%. In parts (b)–(d), do not use the
rule-of-thumb approximation from the lecture notes.
a. What is the price of the bond today?
b. How does the price of the bond change when the yield to maturity increases by
one percentage point?
c. How does the price of the bond change when the yield to maturity decreases by
one percentage point?
d. How do your answers in a.–d. change if you instead assume that the initial yield
to maturity is 5%? Discuss.
3. There are five treasury bonds with a maturity of five years in the market with the
following annual payments and prices:
1
Year 1 Year 2 Year 3 Year 4 Year 5 Price
Bond 1 100 100 100 100 1100 1126
Bond 2 200 200 200 200 1200 1515
Bond 3 50 50 50 50 1050 913
Bond 4 100 100 100 100 2100 1826
Bond 5 100 100 100 100 1600 1476
The yield curve gives the following annual yields to maturity (in percent) for maturities
1 through 5 years, respectively: 3.093%, 4.257%, 4.752%, 5.737%, and 7.394%
Using STRIPS with face value of 50, can you generate an arbitrage given the prices of
the bonds in the market? If so, describe your trading strategy.
Part 2: Modigliani-Miller Theorem
Throughout Part 2 of this problem set, assume perfect capital markets.
1. Project A requires a €100m investment and, one year later, yields €250m, €100m,
or €50m, all with equal probability. A start-up with no assets is considering funding
Project A with equity only or with 50% equity and 50% debt with one-year maturity
and a 10% annual interest rate.
a. In each case, what are the expectation and standard deviation of shareholders’
return? Is one financing option clearly superior to the other?
b. In the second case, answer the same question for debtholders’ return. Is the
debtholders’ expected return more or less than 10%? Why?
2. Alpha Industries and Omega Technology have identical assets generating identical cash
flows. Alpha Industries is an all-equity firm, with 10 million shares outstanding that
trade for $22 per share. Omega Technology has 20 million shares outstanding as well
as debt of $60m.
a. What is the stock price for Omega Technology?
b. Suppose Omega Technology’s stock currently trades for $11 per share. Is an
arbitrage opportunity available? If yes, construct an arbitrage strategy. If not,
explain.
3. ABC Corp. has 2 million shares outstanding and no debt. Each year, it generates
(on average) a $9.6m cash flow which it pays as a regular dividend. ABC’s cost of
capital is 12%, which, since it has no debt, is also its expected return on equity. ABC’s
CEO plans to borrow $8m and use the proceeds immediately to pay shareholders an
exceptional dividend. The debt is perpetual (i.e., interest-only with no repayment of
principal). This level of debt would be risk-free, i.e. the firm would be certain not
to default on its obligation to pay it. The risk-free interest rate is 5%. Answer the
following assuming the transaction (borrowing + dividend) has already occurred.
2
a. What is ABC’s new stock price? Compare it to the initial stock price. Explain.
b. Are ABC’s shareholders happy about the CEO’s change in policy?
c. What is ABC’s annual interest expense? Assuming ABC maintains its policy of
paying all residual cash flows as dividend, what is the new average regular annual
dividend per share?
d. What is ABC’s new expected return on equity? Compare it to the initial 12%.
Explain. Hint: Dividend-discount model
4. Epic Record has 500,000 shares outstanding, a £5m market capitalization and no debt.
The book value of its equity is £1,750,000.
a. What is Epic’s stock price? What is its book value per share?
b. If Epic repurchases 20% of its shares at their current stock price, how will this
a!ect the book value of equity?
c. What would Epic’s market capitalization be after the repurchase? What about
its stock price?
d. Instead of a share repurchase, Epic opts to raise funds by selling an additional
15% of its shares at the current market price. How will this a!ect the book value
of equity?
e. What would Epic’s market capitalization be after the stock issue? What about
its stock price?