ECON 4400
Chapter 6: Questions 1(a), 2(a), 4, 5, 7, 8, 10, 12, 14, 15, 17, 18-29, 31, 34, 35, 36, 40, 41, and
42
Note: Questions are identical in the 7th, 8th, and 9th edition of the book
6.1 The price of a pure discount (zero coupon) bond is the present value of the par.
a. PV = $1,000/(1+0.05)15 = $481.02
6.2 The price of any bond is the PV of the interest payments, plus the PV of the par value. Notice
this problem assumes a semiannual coupon. The price of the bond at each YTM will be:
a. P = $35({1 – [1/(1 + 0.035)30] } / 0.035) + $1,000[1 / (1 + 0.035)30]
P = $1,000.00
When the YTM and the coupon rate are equal, the bond will sell at par.
We would like to introduce shorthand notation here. Rather than write (or type, as the case
may be) the entire equation for the PV of an annuity , it is common to abbreviate the equations
as:
A tr = ({1 – [1/(1 + r) t] }/r )
which stands for Present Value Interest Factor of an Annuity
This abbreviation is short hand notation for the equations in which the interest rate and the
number of periods are substituted into the equation and solved. We will use this shorthand
notation in the remainder of the solutions key.
6.4 Here we need to find the coupon rate of the bond. All we need to do is to set up the bond
pricing equation and solve for the coupon payment as follows:
P = $1,060 = C A 323.8% + $1,000/(1+0.038)23
Solving for the coupon payment, we get:
C = $41.96
Since this is the semiannual payment, the annual coupon payment is:
2 × $41.96 = $83.92
And the coupon rate is the annual coupon payment divided by par value, so:
Coupon rate = $83.92 / $1,000 = 0.0839, or 8.39%
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6.5 The price of any bond is the PV of the interest payment, plus the PV of the par value. The fact
that the bond is denominated in euros is irrelevant. Notice this problem assumes an annual
coupon. The price of the bond will be:
PV = €84 A 15
7.6% + €1,000/(1 + 0.076)
15
PV = €1,070.18
6.7 Here we are finding the prices of the bonds for various maturity lengths. The bond price
equation is:
P = C A tr + $1,000/(1+r)t
Miller Corporation bond:
P1 = $40 A 324% + $1,000/(1+0.03)24 = $1,169.36
P3 = $40 A 320% + $1,000/(1+0.03)20 = $1,148.77
P8 = $40 A10
3% + $1,000/(1+0.03)
10
= $1,085.30
P12 = $40 A 32% + $1,000/(1+0.03)2 = $1,019.13
P13 = $1,000
Modigliani Company bond:
P1 = $30 A 24
4% + $1,000/(1+0.04)
24
= $847.53
P3 = $30 A 20
4% + $1,000/(1+0.04)
20
= $864.10
P8 = $30 A10
4% + $1,000/(1+0.04)
10
= $918.89
P12 = $30 A 24% + $1,000/(1+0.04)2 = $981.14
P13 = $1,000
Bond Price Behavior as Maturity approaches
Bond Price
$1,169.36
$1,148.77 Miller Bond
$1,0000 (Face Value)
Periods until Maturity
$864.10 Modigliani Bond
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$847.53
All else held equal, the premium over par value for a premium bond declines as maturity
approaches, and the discount from par value for a discount bond declines as maturity
approaches. This is called “pull to par.” In both cases, the largest percentage price changes
occur at the shortest maturity lengths.
Also, notice that the price of each bond when no time is left to maturity is the par value, even
though the purchaser would receive the par value plus the coupon payment immediately. This
is because we calculate the clean price of the bond.
6.8 Any bond that sells at par has a YTM equal to the coupon rate. Both bonds sell at par, so the
initial YTM on both bonds is the coupon rate, 7 percent. If the YTM suddenly rises to 9
percent:
PLaurel = $35 A 44.5% + $1,000/(1+0.045)4 = $964.12
PHardy =$35 A 30
4.5% + $1,000/(1+0.045)
30
= $837.11
The percentage change in price is calculated as:
Percentage change in price = (New price – Original price) / Original price
DPLaurel% = ($964.12 – $1,000) / $1,000 = – 0.0359, or –3.59%
DPHardy% = ($837.11 – $1,000) / $1,000 = – 0.1629, or –16.29%
If the YTM suddenly falls to 5 percent:
PLaurel = $35 A 42.5% + $1,000/(1+0.025)4 = $1,037.62
PHardy = $35 A 30
2.5% + $1,000/(1+0.025)
30
= $1,209.30
DPLaurel% = ($1,037.62 – $1,000) / $1,000 = +0.0376, or 3.76%
DPHardy% = ($1,209.30 – $1,000) / $1,000 = +0.2093, or 20.93%
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Bond Price Behavior vs Yield to Maturity
Bond Price
$1,209.3
$1,037.62
$1,000
$964.12 Laurel Bond
$837.11
Hardy Bond
5% 7% 9% Yield to Maturity
All else the same, the longer the maturity of a bond, the greater is its price sensitivity to
changes in interest rates. Notice also that for the same interest rate change, the gain from a
decline in interest rates is larger than the loss from the same magnitude change in interest
rates. For a plain vanilla (standard) bond, this is always true.
6.10 The bond price equation for this bond is:
P0 = $1,050 = $31 A18
r
+ $1,000/(1+r)18
Using a spreadsheet, financial calculator, or trial and error we find:
r = 2.744%
This is the semiannual interest rate, so the YTM is:
YTM = 2 ´ 2.744% = 5.49%
The current yield is:
Current yield = Annual coupon payment / Price = $62 / $1,050 = .0590 or 5.90%
The effective annual yield is the same as the EAR, so using the EAR equation from the
previous chapter:
Effective annual yield = (1 + 0.02744)2 – 1 = 0.0556, or 5.56%
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6.12 To find the number of years to maturity for the bond, we need to find the price of the bond.
Since we already have the coupon rate, we can use the bond price equation, and solve for the
number of years to maturity. We are given the current yield of the bond, so we can calculate
the price as:
Current yield = 0.0842 = $90/PV
PV = $90/0.0842 = $1,068.88
Now that we have the price of the bond, the bond price equation is:
PV = $1,068.88 = $90{[(1 – (1/1.0781 t)]/0.0781} + $1,000/(1.0781)t
We can solve this equation for t as follows:
1,068.88 (1.0781)t = 1,152.37 (1.0781)t – 1,152.37 + 1,000
152.37 = 83.49(1.0781)t
1.8251 = 1.0781t
t = log 1.8251 / log 1.0781 = 8.0004 » 8 years
The bond has 8 years to maturity.
6.14 We found the maturity of a bond in Problem 6.12. However, in this case, the maturity is
indeterminate. A bond selling at par can have any length of maturity. In other words, when
we solve the bond pricing equation as we did in Problem 6.12, the number of periods can be
any positive number.
6.15 To find the capital gains yield and the current yield, we need to find the price of the bond. The
current price of Bond P and the price of Bond P in one year are:
P: P0 = $90 A 10
7% + $1,000/(1+0.07)
10
= $1,140.47
P1 = $90 A 97% + $1,000/(1+0.07)9 = $1,130.30
Current yield = $90 / $1,140.47 = 0.0789, or 7.89%
The capital gains yield is:
Capital gains yield = (New price – Original price) / Original price
Capital gains yield = ($1,130.30 – $1,140.47) / $1,140.47 = – 0.0089, or –0.89%
The current price of Bond D and the price of Bond D in one year are:
D: P0 = $50 A10
7% + $1,000/(1+0.07)
10
= $859.53
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P1 = $50 A 97% + $1,000/(1+0.07)9 = $869.70
Current yield = $50 / $859.53 = 0.0582 or 5.82%
Capital gains yield = ($869.70 – $859.53) / $859.53 = 0.0118, or 1.18%
All else held constant, premium bonds pay a high current income while having price
depreciation as maturity nears; discount bonds pay a lower current income but have price
appreciation as maturity nears. For either bond, the total return is still 7%, but this return is
distributed differently between current income and capital gains.
6.17 The price of any bond (or financial instrument) is the PV of the future cash flows. Even though
Bond M makes different coupons payments, to find the price of the bond, we just find the PV
of the cash flows. The PV of the cash flows for Bond M is:
PM = $800 A16
4% (1/(1+0.04) )+ $1,000 A 4% (1/(1+0.04) ) + $30,000/(1+0.04)
12 12 28 40
PM = $15,200.77
Notice that for the coupon payments of $800, we found the PV for the coupon payments, and
then discounted the lump sum back to today.
Bond N is a zero-coupon bond with a $30,000 par value; therefore, the price of the bond is
the PV of the par, or:
PN = $30,000/(1+0.04)40 = $6,248.67
6.18 The constant dividend growth model is:
Pt = Dt (1 + g)/(r – g)
So, the price of the stock today is:
P0 = D0(1 + g)/(r – g) = $2.15(1.05)/(0.11– 0.05) = $37.63
P3 = D4/(r – g) = D0(1 + g)4/(r – g) = $2.15 (1.05)4/(0.11 – 0.05) = $43.56
We can do the same thing to find the dividend in Year 16, which gives us the price in Year
15, so:
P15 = D15(1 + g)/(r – g) = D0(1 + g)16/(r – g) = $2.15(1.05)16/(0.11 – 0.05) = $78.22
There is another feature of the constant dividend growth model: The stock price grows at the
dividend growth rate. So, if we know the stock price today, we can find the future value for
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any time in the future we want to calculate the stock price. In this problem, we want to know
the stock price in three years, and we have already calculated the stock price today. The stock
price in three years will be:
P3 = P0(1 + g)3 = $37.63(1 + 0.05)3 = $43.56
And the stock price in 15 years will be:
P15 = P0(1 + g)15 = $37.63(1 + 0.05)15 = $78.23 (price difference is due to rounding)
6.19 We need to find the required return of the stock. Using the constant growth model, we can
solve the equation for R. Doing so, we find:
r = (D1 / P0) + g = ($3.20 / $63.50) + 0.06 = 0.1104, or 11.04%
6.20 The dividend yield is the dividend next year divided by the current price, so the dividend yield
is:
Dividend yield = D1 / P0 = $3.20 / $63.50 = 0.0504, or 5.04%
The capital gains yield, or percentage increase in the stock price, is the same as the dividend
growth rate, so:
Capital gains yield = 6%
6.21 Using the constant growth model, we find the price of the stock today is:
P0 = D1/(r – g) = $3.05/(0.11 – 0.0525) = $53.04
6.22 The required return of a stock is made up of two parts: The dividend yield and the capital
gains yield. So, the required return of this stock is:
r = Dividend yield + Capital gains yield = 0.043 + 0.064 = 0.1070, or 10.70%
6.23 We know the stock has a required return of 11.5 percent, and the dividend and capital gains
yield are equal, so:
Dividend yield = 1/2(0.115) = 0.0575 = Capital gains yield
Now we know both the dividend yield and capital gains yield. The dividend is simply the
stock price times the dividend yield, so:
D1 = 0.0575($72) = $4.14
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This is the dividend next year. The question asks for the dividend this year. Using the
relationship between the dividend this year and the dividend next year:
D1 = D0(1 + g)
We can solve for the dividend that was just paid:
$4.14 = D0 (1 + 0.0575)
D0 = $4.14 / 1.0575 = $3.91
6.24 The price of any financial instrument is the PV of the future cash flows. The future dividends
of this stock are an annuity for 12 years, so the price of the stock is the PVA, which will be:
P0 = $9 A1210% = $61.32
6.25 The price of a share of preferred stock is the dividend divided by the required return. This is
the same equation as the constant growth model, with a dividend growth rate of zero percent.
Remember that most preferred stock pays a fixed dividend, so the growth rate is zero. Using
this equation, we find the required return on the preferred stock is:
r = D/P0 = $5.90/$87 = 0.0678, or 6.78%
6.26 The growth rate of earnings is the return on equity times the retention ratio, so:
g = ROE × b
g = 0.15 × 0.70
g = 0.1050 or 10.50%
To find next year’s earnings, we simply multiply the current earnings times one plus the
growth rate, so:
Next year’s earnings = Current earnings (1 + g)
Next year’s earnings = $28,000,000 (1+0.1050)
Next year’s earnings = $30,940,000
6.27 This stock has a constant growth rate of dividends, but the required return changes twice. To
find the value of the stock today, we will begin by finding the price of the stock at Year 6,
when both the dividend growth rate and the required return are stable forever. The price of
the stock in Year 6 will be the dividend in Year 7, divided by the required return minus the
growth rate in dividends. So:
P6 = D6 (1 + g) / (r – g) = D0 (1 + g)7 / (r – g) = $3.10(1.06)7 / (0.11 – 0.06) = $93.23
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Now we can find the price of the stock in Year 3. We need to find the price here since the
required return changes at that time. The price of the stock in Year 3 is the PV of the dividends
in Years 4, 5, and 6, plus the PV of the stock price in Year 6. The price of the stock in Year 3
is:
P3 = $3.10(1.06)4 / 1.13 + $3.10(1.06)5 / 1.132 + $3.10(1.06)6 / 1.133 + $93.23 / 1.133
P3 = $74.37
Finally, we can find the price of the stock today. The price today will be the PV of the
dividends in Years 1, 2, and 3, plus the PV of the stock in Year 3. The price of the stock today
is:
P0 = $3.10(1.06) / 1.15 + $3.10(1.06)2 / (1.15)2 + $3.10(1.06)3 / (1.15)3 + $74.37 / (1.15)3
P0 = $56.82
6.28 Here we have a stock that pays no dividends for 9 years. Once the stock begins paying
dividends, it will have a constant growth rate of dividends. We can use the constant growth
model at that point. It is important to remember that general form of the constant dividend
growth formula is:
Pt = [Dt (1 + g)] / (r– g)
This means that since we will use the dividend in Year 10, we will be finding the stock price
in Year 9. The dividend growth model is similar to the PV of an annuity and the PV of a
perpetuity: The equation gives you the PV one period before the first payment. So, the price
of the stock in Year 9 will be:
P9 = D10/(r – g) = $9.00/(0.13 – 0.055) = $120.00
The price of the stock today is simply the PV of the stock price in the future. We simply
discount the future stock price at the required return. The price of the stock today will be:
P0 = $120.00/1.139 = $39.95
6.29 The price of a stock is the PV of the future dividends. This stock is paying five dividends,
so the price of the stock is the PV of these dividends using the required return. The price of
the stock is:
P0 = $15 / 1.12 + $18 / 1.122 + $21 / 1.123 + $24 / 1.124 + $27 / 1.125 = $73.26
6.31 With differential dividends, we find the price of the stock when the dividends level off at a
constant growth rate, and then find the PV of the future stock price, plus the PV of all
dividends during the differential growth period. The stock begins constant growth in Year 4,
so we can find the price of the stock in Year 3, one year before the constant dividend growth
begins as:
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P3 = D3 (1 + g) / (r – g) = D0 (1 + g1)3 (1 + g2) / (r – g2) = $2.80(1.20)3(1.05) / (0.12 – 0.05)
= $72.58
The price of the stock today is the PV of the first three dividends, plus the PV of the Year 3
stock price. The price of the stock today will be:
P0 = $2.80(1.20) / 1.12 + $2.80(1.20)2 / 1.122 + $2.80(1.20)3 / 1.123 + $72.58 / 1.123
P0 = $61.32
6.34 We are given the stock price, the dividend growth rate, and the required return, and are asked
to find the dividend. Using the constant dividend growth model, we get:
P0 = $58.32 = D0 (1 + g) / (r – g)
Solving this equation for the dividend gives us:
D0 = $58.32(0.115 – 0.05) / (1.05) = $3.61
6.35 The price of a share of preferred stock is the dividend payment divided by the required return.
We know the dividend payment in Year 5, so we can find the price of the stock in Year 4, one
year before the first dividend payment. Doing so, we get:
P4 = $8.00 / .056 = $142.86
The price of the stock today is the PV of the stock price in the future, so the price today will
be:
P0 = $142.86 / (1.056)4 = $114.88
6.36 The dividend yield is the annual dividend divided by the stock price, so:
Dividend yield = Dividend / Stock price
0.019 = Dividend / $26.18
Dividend = $0.50
The “Net Chg” of the stock shows the stock decreased by $0.13 on this day, so the closing
stock price yesterday was:
Yesterday’s closing price = $26.18 – (– 0.13) = $26.31
To find the net income, we need to find the EPS. The stock quote tells us the P/E ratio for the
stock is 23. Since we know the stock price as well, we can use the P/E ratio to solve for EPS
as follows:
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P/E = 23 = Stock price / EPS = $26.18 / EPS
EPS = $26.18 / 23 = $1.14
We know that EPS is just the total net income divided by the number of shares outstanding,
so:
EPS = NI / Shares = $1.14 = NI / 25,000,000
NI = $1.14(25,000,000) = $28,500,000
6.40 First, we need to find the annual dividend growth rate over the past four years. To do this, we
can use the future value of a lump sum equation, and solve for the interest rate. Doing so, we
find the dividend growth rate over the past four years was:
FV = PV(1 + r)t
$1.77 = $1.35(1 + r)4
r = ($1.77 / $1.35)1/4 – 1
r = 0.0701, or 7.01%
We know the dividend will grow at this rate for five years before slowing to a constant rate
indefinitely. So, the dividend amount in seven years will be:
D7 = D0(1 + g1)5(1 + g2)2
D7 = $1.77(1 + 0.0701)5(1 + 0.05)2
D7 = $2.74
6.41 a. We can find the price of all the outstanding company stock by using the dividends the same
way we would value an individual share. Since earnings are equal to dividends, and there is
no growth, the value of the company’s stock today is the present value of a perpetuity, so:
P=D/r
P = $750,000/0.14
P = $5,357,142.86
The price-earnings ratio is the stock price divided by the current earnings, so the price-
earnings ratio of each company with no growth is:
P/E = Price / Earnings
P/E = $5,357,142.86/$750,000
P/E = 7.14 times
b. Since the earnings have increased, the price of the stock will increase. The new price of
the all the outstanding company stock is:
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P=D/r
P = ($750,000+$100,000)/0.14
P = $6,071,428.57
The price-earnings ratio is the stock price divided by the current earnings, so the price-
earnings with the increased earnings is:
P/E = Price / Earnings
P/E = $6,071,428.57/$750,000
P/E = 8.10 times
c. Since the earnings have increased, the price of the stock will increase. The new price of
the all the outstanding company stock is:
P=D/r
P = ($750,000 + $200,000)/0.14
P = $6,785,714.29
The price-earnings ratio is the stock price divided by the current earnings, so the price-
earnings with the increased earnings is:
P/E = Price / Earnings
P/E = $6,785,714.29/$750,000
P/E = 9.05 times
6.42 a. If the company does not make any new investments, the stock price will be the present
value of the constant perpetual dividends. In this case, all earnings are paid as dividends,
so, applying the perpetuity equation, we get:
P = Dividend / r
P = $8.25/0.12
P = $68.75
b. The investment is a one-time investment that creates an increase in EPS for two years.
To calculate the new stock price, we need the cash cow price plus the NPVGO. In this
case, the NPVGO is simply the present value of the investment plus the present value of
the increases in EPS. So, the NPVGO will be:
NPVGO = C1/(1 + r) + C2/(1 + r)2 + C3/(1 + r)3
NPVGO = –$1.60/1.12 + $2.10/1.122 + $2.45/1.123
NPVGO = $1.99
So, the price of the stock if the company undertakes the investment opportunity will be:
P = $68.75 + $1.99
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P = $70.74
c. After the project is over, and the earnings increase no longer exists, the price of the stock
will revert back to $68.75, the value of the company as a cash cow.
with a maturity of 1 year.
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