Chapter 8 - Bond valuation

7.
To find the price of a zero coupon bond, we need to find the value of the future cash flows.
With a zero coupon bond, the only cash flow is the par value at maturity. We find the
present value assuming semiannual compounding to keep the YTM of a zero coupon bond
equivalent to the YTM of a coupon bond, so:

P = $10,000(PVIF2.10%,48)
P = $3,687.77

11. The Fisher equation, which shows the exact relationship between nominal interest rates,
real interest rates, and inflation is:

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

R = (1 + .018)(1 + .027) – 1
R = .0455, or 4.55%

12. The Fisher equation, which shows the exact relationship between nominal interest rates,
real interest rates, and inflation is:

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

h = [(1 + .117)/(1 + .09)] – 1

h = .0248, or 2.48%

16. Zero coupon bonds are priced with semiannual compounding to correspond with coupon
bonds. The price of the bond when purchased was:

P0 = $1,000/(1 + .0265)50
P0 = $270.43

And the price at the end of one year is:

P1 = $1,000/(1 + .0265)48
P1 = $284.95

So, the implied interest, which will be taxable as interest income, is:

Implied interest = $284.95 – 270.43

Implied interest = $14.52

Intermediate
18. 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, 7.1 percent. If the YTM suddenly rises to
9.1 percent:

PSam = $35.50(PVIFA4.55%,6) + $1,000(PVIF4.55%,6) = $948.50

PDave = $35.50(PVIFA4.55%,40) + $1,000(PVIF4.55%,40) = $817.29

The percentage change in price is calculated as:

Percentage change in price = (New price – Original price)/Original price

PSam% = ($948.50 – 1,000)/$1,000 = –.0515, or –5.15%

PDave% = ($817.29 – 1,000)/$1,000 = –.1827, or –18.27%

If the YTM suddenly falls to 5.1 percent:

PSam = $35.50(PVIFA2.55%,6) + $1,000(PVIF2.55%,6) = $1,054.99

PDave = $35.50(PVIFA2.55%,40) + $1,000(PVIF2.55%,40) = $1,248.93

PSam% = ($1,054.99 – 1,000)/$1,000 = .0550, or 5.50%

PDave% = ($1,248.93 – 1,000)/$1,000 = .2489, or 24.89%

All else the same, the longer the maturity of a bond, the greater is its price sensitivity to
changes in interest rates.

YTM and Bond Price

$2,500
$2,000
Bond Price

$1,500 Bond Sam

Bond Dave
$1,000
$500
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Yield to Maturity

21. The company should set the coupon rate on its new bonds equal to the required
return. The required return can be observed in the market by finding the YTM on the
 outstanding bonds of the company. So, the YTM on the bonds currently sold in the market
is:

P = $967 = $30(PVIFAR%,40) + $1,000(PVIFR%,40)

Using a spreadsheet, financial calculator, or trial and error we find:

R = 3.146%

This is the semiannual interest rate, so the YTM is:

YTM = 2  3.146%
YTM = 6.29%

Chapter 9 - Stock valuation

7. The price of any financial instrument is the PV of the future cash flows. The future
dividends of this stock are an annuity for 13 years, so the price of the stock is the PVA,
which will be:

P0 = $9.45(PVIFA10.7%,13)
P0 = $64.76

8. 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, most preferred stock pays a fixed dividend, so the growth rate is zero.
Using this equation, we find the required return of the preferred stock is:

R = D/P0
R = $3.80/$93
R = .0409, or 4.09%

9. The growth rate of earnings is the return on equity times the retention ratio, so:

g = ROE × b
g = .12(.80)
g = .096, or 9.60%

To find next year’s earnings, we multiply the current earnings times one plus the growth
rate, so:

Next year’s earnings = Current earnings(1 + g)

Next year’s earnings = $19,200,000(1 + .0960)
 Next year’s earnings = $21,043,200

16. Here we need to find the dividend next year for a stock experiencing nonconstant growth.
We know the stock price, the dividend growth rates, and the required return, but not the
dividend. First, we need to realize that the dividend in Year 3 is the current dividend times
the FVIF. The dividend in Year 3 will be:

D3 = D0(1.25)3

And the dividend in Year 4 will be the dividend in Year 3 times one plus the growth rate, or:

D4 = D0(1.25)3(1.15)

The stock begins constant growth in Year 4, so we can find the price of the stock in Year 4
as the dividend in Year 5, divided by the required return minus the growth rate. The
equation for the price of the stock in Year 4 is:

P4 = D4(1 + g)/(R – g)

Now we can substitute the previous dividend in Year 4 into this equation as follows:

P4 = D0(1 + g1)3(1 + g2)(1 + g3)/(R – g)

P4 = D0(1.25)3(1.15)(1.06)/(.10 – .06)
P4 = 59.52D0

When we solve this equation, we find that the stock price in Year 4 is 59.52 times as large
as the dividend today. Now we need to find the equation for the stock price today. The
stock price today is the PV of the dividends in Years 1, 2, 3, and 4, plus the PV of the Year 4
price. So:

P0 = D0(1.25)/1.10 + D0(1.25)2/1.102 + D0(1.25)3/1.103+ D0(1.25)3(1.15)/1.104 + 59.52D0/1.104

We can factor out D0 in the equation and combine the last two terms. Doing so, we get:

P0 = $86 = D0{1.25/1.10 + 1.252/1.102 + 1.253/1.103 + [(1.25)3(1.15) + 59.52]/1.104}

Reducing the equation even further by solving all of the terms in the braces, we get:

$86 = $46.08D0
D0 = $86/$46.08
D0 = $1.87

This is the dividend today, so the projected dividend for the next year will be:
 D1 = $1.87(1.25)
D1 = $2.33

17. The constant growth model can be applied even if the dividends are declining by a constant
percentage, just make sure to recognize the negative growth. So, the price of the stock
today will be:

P0 = D0(1 + g)/(R – g)
P0 = $12.40(1 – .04)/[(.095 – (–.04)]
P0 = $88.18

23. The required return of a stock consists of two components, the capital gains yield and the
dividend yield. In the constant dividend growth model (growing perpetuity equation), the
capital gains yield is the same as the dividend growth rate, or algebraically:

R = D1/P0 + g

We can find the dividend growth rate by the growth rate equation, or:

g = ROE × b
g = .11 × .60
g = .0660, or 6.60%

This is also the growth rate in dividends. To find the current dividend, we can use the
information provided about the net income, shares outstanding, and payout ratio. The
total dividends paid is the net income times the payout ratio. To find the dividend per
share, we can divide the total dividends paid by the number of shares outstanding. So:

Dividend per share = (Net income × Payout ratio)/Shares outstanding

Dividend per share = ($25,000,000 × .40)/2,900,000
Dividend per share = $3.45

Now we can use the initial equation for the required return. We must remember that the
equation uses the dividend in one year, so:

R = D1/P0 + g
R = $3.45(1 + .0660)/$109 + .0660
R = .0997, or 9.97%

25. 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 = $790,000/.11
P = $7,181,818.18

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:

PE = Price/Earnings
PE = $7,181,818.18/$790,000
PE = 9.09 times

b. Since the earnings have increased, the price of the stock will increase. The new price of the
outstanding company stock is:

P = D/R
P = ($790,000 + 175,000)/.11
P = $8,772,727.27

The price-earnings ratio is the stock price divided by the current earnings, so the price-
earnings ratio with the increased earnings is:

PE = Price/Earnings
PE = $8,772,727.27/$790,000
PE = 11.10 times

c. Since the earnings have increased, the price of the stock will increase. The new price
of the outstanding company stock is:

P = D/R
P = ($790,000 + 350,000)/.11
P = $10,363,636.36

The price-earnings ratio is the stock price divided by the current earnings, so the price-
earnings ratio with the increased earnings is:

PE = Price/Earnings
PE = $10,363,636.36/$790,000
PE = 13.12 times

26. a. Using the equation to calculate the price of a share of stock with the PE ratio:

P = Benchmark PE ratio × EPS

So, with a PE ratio of 21, we find:

 P = 21($4.05)
P = $85.05

b. First, we need to find the earnings per share next year, which will be:

EPS1 = EPS0(1 + g)
EPS1 = $4.05(1 + .049)
EPS1 = $4.25

Using the equation to calculate the price of a share of stock with the PE ratio:

P1 = Benchmark PE ratio × EPS1

P1 = 21($4.25)
P1 = $89.22

c. To find the implied return over the next year, we calculate the return as:

R = (P1 – P0)/P0
R = ($89.22 – 85.05)/$85.05
R = .049, or 4.9%

Notice that the return is the same as the growth rate in earnings. Assuming a stock
pays no dividends and the PE ratio is constant, this will always be true when using
price ratios to evaluate the price of a share of stock.

32. Here we want to find the required return that makes the PV of the dividends equal to the
current stock price. The equation for the stock price is:

$67.25 = $3.65(1.20)/(1 + R) + $3.65(1.20)(1.15)/(1 + R)2 + $3.65(1.20)(1.15)(1.10)/(1 + R)3

+ [$3.65(1.20)(1.15)(1.10)(1.05)/(R – .05)]/(1 + R)3

We need to find the roots of this equation. Using spreadsheet, trial and error, or a
calculator with a root solving function, we find that:

R = 12.39%