Bond Prices

Coupon Rate Number of Periods Remaining Payments per year YTM Assumed Face Value Coupon Value Current Bond Price OR Using Built In Excel Functions Settlement Date: Maturity Date: Annual Coupon rate: Yield to Maturity: Face Value (% of par): Coupons per year: Bond Price (% of par) Bond Price ($) 8% 10 1 6% $1,000 $80 $1,147.20

DTO Inc, Inc.

1/1/2000 1/1/2010 0.08 0.06 100 1 114.72 $1,147.20 Check

Bond Yields

Aragon Co.

Coupon Rate Number of Periods Remaining Payments per year Current Price Assumed Face Value Coupon Value Yield to Maturity (YTM) OR Using Built In Excel Functions

9% 9 1 $884.50 $1,000 $90 11.0935%

Settlement Date: Maturity Date: Annual Coupon rate: Bond Price (% of par) Face Value (% of par): Coupons per year: Yield to Maturity:

1/1/2000 1/1/2009 0.09 88.45 100 1 11.0935% Check

YTM Worksheet (By trial error try to find the YTM): Calculated Bond Price: Estimated YTM (Guess): $884.50 Target: 11.0935% $884.50 $1,769.00 Try different values and try to get given Bond Price to find YTM

d try to get given

Calculating Real Rates of Return

T-Bills are paying: Inflation Rate: Approximate Real Rate of Interest: Exact Real Rate of Interest: 6.00% 4.50% 1.50% 1.44% Formula: Formula: r=real rate of interest R=nominal interest rate h= inflation rate

r=R-h (approximate) r=(R-h)/(1+h)

Inflation and Nominal Returns

r=real rate of interest R=nominal interest rate h= inflation rate

Real Interest Rate (r): Inflation Rate (h): T-Bills should be expected to pay:

4.00% 2.50% 6.60% Formula:

R=(1+r) x (1+h) - 1

Bond Yields
Coupon Rate: Years to Maturity: Payment freq.: Payment % of PAR: Assumed face value: Current Price: Annual Coupon: Current Yield: YTM: Effective Annual Yield: 8.40% 9 2 104 $1,000 $1,040 $84 8.08% 7.76% 7.91%

OR Using Excel Built In Functions: Make Estimate Settlement Date: Maturity Date: Annual Coupon rate: Bond Price (% of par) Face Value (% of par): Coupons per year: Yield to Maturity: 1/1/2000 1/1/2009 0.084 104 100 2 7.77%

YTM Calculation Worksheet: 3.88% 1.0409077404 Since this pays twice a year: YTM = 2 * 6 month rate =

n Worksheet: Target:

1.04 (104% of PAR)

wice a year: 7.76%

Bond Prices versus Yields

Part a: Bond Price = C x [1 - 1/(1 + r)^t]/r + F/(1 + r)^t where: C = Coupon Paid Each Period r = rate per period t = number of periods F = Bond's face value

Part b:

Why do some bonds sell at a premium over par value while other bonds sell at a discount?

Bond value is determined in two parts. One part takes into account the cash flows due to the annuity component based on the "coupons" that are paid periodically. The Annuity present value is = C * (1 - (1/1 + r)^t)/r where C is and r is the yield to maturity

A second component is the Lump Sum or face value that is paid at some point in the future. This is calculated as PV = F/(1 + r)^t where F is the face value of the bond and r is the yield to maturity

The cash flows from a bond remain constant while interest rates fluctuate. Therefore investors will decide how they will pay for an investment based on the current interest rates and weigh the risk/reward of investing in the bond. Because of this the price of the bond will fluctuate. The bond's Yield to Maturity r is the interest rate requi

The relationship between the Coupon Rate and the YTM for premium bonds:

The coupon rate is simply the annual coupon value of the bond divided by the face value. It never changes. YTM On a premium bond, YTM is less than the coupon rate

The relationship between the Coupon Rate and the YTM for discount bonds:

On a discount bond, YTM is greater than the coupon rate

For bonds selling at PAR value the Coupon Rate equals the YTM

Part c:

What is the relationship between the current yield and YTM for premium bonds?

The current yield on a premium bond is higher than the Yield to Maturity for premium bonds because the current into account the fact that there is a built-in loss on premium bonds. The current yield only reflects the coupon po In fact: Coupon Rate > Current Yield > YTM for Premium Bonds What is the relationship between the current yield and YTM for discount bonds?

The current yield on a discount bond is lower than the Yield to Maturity for the discount bond because the curren into account the fact that there is a built-in gain on discount bonds. The current yield only reflects the coupon po In fact: Coupon Rate < Current Yield < YTM for Premium Bonds

What is the relationship between the current yield and YTM for bonds selling at PAR value? The current yield on a bond selling at PAR/FACE value is equal to the Yield to Maturity for the bond. In fact: Coupon Rate = Current Yield = YTM for Premium Bonds

to the annuity component of the bond. This is - (1/1 + r)^t)/r where C is the coupon value

ture. This is calculated as follows:

investors will decide how much ward of investing in the r is the interest rate required by the market for the cash flows the bond produces

It never changes. YTM will fluctuate with interest rates.

onds because the current yield does not take nly reflects the coupon portion of the return.

bond because the current yield does not take nly reflects the coupon portion of the return.

for the bond.

Stock Values
Dividend Amount Growth Rate Current Price

MUG Inc. $3.10 D 5.00% $48.00

D1
g

P0

P 0=

D1 ( R g )

Therefore:

R=

D1 P0

+g

Required Rate of Return

11.46%

Stock Values
Dividend Amount Growth Rate Required Return

Warren Corporation

$3.60 D 4.50% 13.00%

D1
g R

P 0=
Current Price

D1 ( R g )
P0

$42.35

Nonconstant Growth

Metallica Bearings, Inc.

start

Starting in Year 10: Dividend Amount Growth Rate Required Return $8.00 6.00% 13.00%

D 10
g R

P 9=
Price in Year 10

D 10 ( R g )
P9

$114.29

PV =

FV ( 1 + R )9

Price today

$38.04

10

etc.

Starting in year 10 an $8 dividend will be paid that will increase by 6% each year thereafter.

Supernormal Growth

Rizzi Corporation

NOTE: Start from Year 0:

Initial Dividend Amount Growth Rate

$2.80 25.00%

D0
g

Divendend Worksheet: Year 0 $2.80 Year 1 $3.50 Year 2 $4.38 Year 3 $5.47 Year 4 $5.85 Year 5 $6.26 Year 6 $6.70 Etc.

Starting in Year 3: Year 3 Dividend Growth Rate Required Return

$5.47 7.00% 13.00%

D4
g R

P 3=
Price in Year 3

D 3 ( 1 + g ) R g
P3

$97.53

P 0=

D1 D2 D3 P3 + + + ( 1 + R ) ( 1 + R )2 ( 1 + R )3 ( 1 + R )3

Price today

$77.90

nd Worksheet:

D1
D3

25% Growth Starts from here

D2

7% Growth Starts from here

NPV versus IRR

Year 0 1 2 3

Cash Flow (X) Cash Flow (Y) -$5,000.00 -$5,000.00 $2,700.00 $2,300.00 $1,700.00 $1,800.00 $2,300.00 $2,700.00 16.60%

IRR 16.82% Done by built in Excel Function IRR Check

NPV Discount Rate Project X 0% $1,700.00 5% $1,100.21 10% $587.53 15% $145.56 20% -$238.43 25% -$574.40 13.28% $290.48

Formula for IRR Project X:

0 =5000 +

2700 1700 2300 + + ( 1 + IRR ) ( 1 + IRR )2 ( 1 + IRR )3

$0.00 Formula for IRR Project Y:

16.82%

0 =5000 +

2300 1800 2700 + + ( 1 + IRR ) ( 1 + IRR )2 ( 1 + IRR )3

$0.00

16.60%

NPV Project Y $1,800.00 $1,155.49 $607.06 $136.35 -$270.83 -$625.60 $290.47

We can see that the crossover occurs somewhere here This is because NPV-X is > NPV-Y whereas before NPV-X was less than NPV-Y

Using Trial and Error we find the correct value with guesses between 10 an

This check is done by plugging in the IRR calculated above into the formula

This check is done by plugging in the IRR calculated above into the formula

with guesses between 10 and 15 percent

Problems with IRR

Year 0 1 2 Cash Flow -$28,000,000.00 $53,000,000.00 -$8,000,000.00 Return Required:

a.

If the company requires a 10 percent return on its investments, should it accept this project? Why? First calculate the NPV for the project: $13,570,248 $13,570,248

NPV = 28 , 000 .000 +

b.

53 , 000 , 000 8,000 , 000 ( 1 + .1 ) ( 1 + .1 )2

Compute the IRR for this project.

0 = 28 , 000 .000 +

53 , 000 , 000 8,000 , 000 ( 1 + IRR ) ( 1 + IRR )2

With the formula above guesses must be made: -83.46046% 72.74617% $0.06 Close to Zero $0.07 Close to Zero We know there will be two IRRs because of the sign change.

This must be done by trial error. Guess IRR One Guess IRR Two

How many IRRs are there?

If you apply the IRR decision rule, should you accept the project or not? In this case, the IRR decision is ambiguous since there are two IRRs and therefore one should not use the IRR to make a decision in this case.

10%

ld it accept this project? Why?

Yes since NPV is > 0 the company should accept this project

Check

Rs because of the sign change.

IRRs and therefore one

IRR Guess NPV -99% -$74,728,000,000.00 -90% -$298,000,000.00 -80% $37,000,000.00 -70% $59,777,777.78 -60% $54,500,000.00 -50% $46,000,000.00 -40% $38,111,111.11 -30% $31,387,755.10 -20% $25,750,000.00 -10% $21,012,345.68 0% $17,000,000.00 10% $13,570,247.93 20% $10,611,111.11 30% $8,035,502.96 40% $5,775,510.20 50% $3,777,777.78 60% $2,000,000.00 70% $408,304.50 80% -$1,024,691.36 90% -$2,321,329.64 99% -$3,386,985.18

Sign Change: IRR is between -80% an

Sign Change: IRR is between 70% and

nge: IRR is between -80% and -90%

nge: IRR is between 70% and 80%

Comparing Investment Criteria

Year 0 1 2 3 4 Cash Flow (A) Discounted (A) Cash Flow (B) Discounted (B) Required Return: -$210,000.00 -$210,000.00 -$21,000.00 -$21,000.00 $15,000.00 $13,043.48 $11,000.00 $9,565.22 $30,000.00 $22,684.31 $9,000.00 $6,805.29 $30,000.00 $19,725.49 $11,000.00 $7,232.68 $370,000.00 $211,548.70 $9,000.00 $5,145.78

a.

If you apply the payback criterion, which investment will you choose? Why? Project A Payback 3.36 Years Project B Payback 2.09 Years Project B would be chosen b

b.

If you apply the discounted payback criterion, which investment will you choose? Why? Project A Payback Project B Payback 3.73 Years 2.64 Years

Project B would be chosen b

c.

If you apply the NPV criterion, which investment will you choose? Why? Project A NPV Project B NPV $57,001.98 $7,748.97

Project A would be chosen b

d.

If you apply the IRR criterion, which investment will you choose? Why? Project A IRR Project B IRR 22.97% 32.73%

Project B would be chosen b

e.

If you apply the profitability index criterion, which investment will you choose? Why? Profitability Index A Profitability Index B 1.27 1.37

Project B would be chosen b

f.

Based on your answers in (a) through (e), which project will you finally choose? Why? Even though project B was deemed superior in all comparisons except for NPV, I would still Choose Project A. First, although project B wins with IRR and Profitability Index, both of these measures are not considered to be accurate for Mutally Exclusive Projects Second, the payback rules seem to indicate that Project B is superior, however, due to the fact that the NPV is so much higher for Project A, I would choose project A.

Required Return:

15%

Project B would be chosen because it has the smaller payback period

hoose? Why?

Project B would be chosen because it has the smaller dicounted payback period

Project A would be chosen because it has the higher NPV

Project B would be chosen because it has the higher IRR

Project B would be chosen because it has the higher Profitability Index

oose? Why?

ept for NPV, I would still ofitability Index, both lusive Projects. r, however, due to the fact

Portfolio Expected Return

Stock X Y Z Expected Portfolio Return 13.4% Expected Return 11% 17% 14% Percent Invested 50% 30% 20%

Formula: Expected Return * Percent Invested

Calculating Returns and Standard Deviations

State of Economy Stock A Recession Normal Boom

Probability of Rate of Return State of If State Occurs Economy 0.1 0.6 0.3 0.06 0.07 0.11 Expected Return Stock A

Return Deviation from Expected Expected Return Return 0.60% 4.20% 3.30% -2.10% -1.10% 2.90%

8.10%

Stock B Recession Normal Boom

0.1 0.6 0.3

-0.2 0.13 0.33 Expected Return Stock

-2.00% 7.80% 9.90%

-35.70% -2.70% 17.30%

15.70%

Product of Probability State of Economy and Squared Return Squared Deviation from Return Standard Expected Return Deviation Deviation 0.000441 0.000121 0.000841 0.0000441 0.0000726 0.0002523

Sigma Squared Deviation For Stock A

0.000369

1.92%

Stock A

Sigma Squared Deviation For Stock B

0.127449 0.000729 0.029929

0.0127449 0.0004374 0.0089787

0.022161

14.89%

Stock B

Calculating Portfolio Betas

Stock Q R S T

Portfolio Percent Beta 25% 0.6 20% 1.7 15% 1.15 40% 1.34 Portfolio Beta 1.20 Sum of (Percent Portfolio * Beta) for each stock

Using CAPM
Beta Expected Market Return Risk Free Rate 1.3

14%

5%

Expected Return

16.70%

E ( R i )= R f +[ E ( R M ) R f ] i

Using CAPM
Market Risk Premium Stock Expected Return Risk Free Rate Beta

6%

14%

4% 1.67

E ( R i )= R f +[ E ( R M ) R f ] i

i=

E ( R i ) R f [ E ( R M ) R f ]

therfore:

R f

) R f ]

Denominator is Market Risk Premium

Using CAPM
Beta Stock Expected Return Risk Free Rate 0.85

11%

6%

Expected Return

11.97%

E ( R i )= R f +[ E ( R M ) R f ] i
Therefore:

E ( R M )=

[ E ( R i ) R f ] i

+Rf

+Rf