Chapter 2: Investment Instruments

1. Consider a 90-days treasury bill, issued today, which is selling for Rs 98,500. Its face value is Rs 100,000.
(a) What is 90 days discount rate?
(b) What is the annual discount based on the selling price of the security?
(c) What is 90 days yield or HPR?
(d) What is the annual equivalent yield of the security?
2. A bank has issued a 6-month, Rs 1 million negotiable CD with a 4.1 percent annual interest rate. How much of amount of
interest will earned by depositor at the end of 6-months period? How much of amount in six months in exchange the
depositor requires for Rs 1 million deposited in the bank today? Immediately after the CD is issued, the market rate on the Rs
1 million CD rises to 4.6 percent. What is the secondary market price of this CD?
3. Assume you found the following quotation for a Treasury bill in an issue of the Wall Street Journal:
Maturity Days to maturity Bid Ask Change Ask yield
11/14/24 170 5.57 5.55 – 0.03 5.79
(a) What does 'Days to mat. 170' mean?
(b) Explain the difference between the "bid" and "ask" quotes. Is bid quote always higher than the ‘ask’ quote? Calculate
the bid and ask price assuming Rs 10,000 face value.
(c) Explain the "change" of  0.03. Calculate the previous day's bid price assuming Rs 10,000 face value.
(d) Notice that the bill matures in 170 days and has an "ask yield" of 5.79 percent. Is this a 170-day yield or an annualized
yield? Show how this yield is calculated?
4. Treasury Department announced the issue of Rs 12.44 billion of Treasury bills. Rupees 3.44 billion is separated for the
non-competitive bidders. The remaining will be allocated among competitive bidders. The Dutch auction method is
applied. The following competitive bids were received.

Amount (Rs billions) Bid (yield %)

Rs 0.20 7.55% (lowest yield)
0.26 7.56
0.33 7.57
0.57 7.58
0.79 7.59
0.96 7.60
1.25 7.61
1.52 7.62
2.00 7.63
1.12 7.64
1.10 7.65
No bids above 7.65%
a. How much is available to be awarded to competitive bidders?
b. What is the stop yield?
c. Which bidders will be awarded securities?
d. At what yield will a winning bidder be awarded securities?
e. If a bidder bids for $10 million at the stop yield, how much will be awarded to that bidder?
f. What is the bid-to-cover ratio for this auction?
5. You are bullish on Telecom stock. The current market price is $50 per share, and you have $5,000 of your own to
invest. You borrow an additional $5,000 from your broker at an interest rate of 8% per year and invest $10,000 in the
stock.
a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next year? The stock
currently pays no dividends. [Ans: 12%]
b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%?
Assume the price fall happens immediately. [Ans: 35.71 or lower]
6. You are bearish on Telecom and decide to sell short 100 shares at the current market price of $50 per share.
a. How much in cash or securities must you put into your brokerage account if the broker’s initial margin requirement
is 50% of the value of the short position? [Ans: 2500]
b. How high can the price of the stock go before you get a margin call if the maintenance margin is 30% of the value
of the short position? [57.69 or higher]
7. Suppose that Xtel currently is selling at $20 per share. You buy 1,000 shares using $15,000 of your own money,
borrowing the remainder of the purchase price from your broker. The rate on the margin loan is 8%.
a. What is the percentage increase in the net worth of your brokerage account if the price of Xtel immediately changes
to: (i) $22; (ii) $20; (iii) $18? What is the relationship between your percentage return and the percentage change in
the price of Xtel? [Ans: 13.33%, 0%, -13.33%]
b. If the maintenance margin is 25%, how low can Xtel’s price fall before you get a margin call? [Ans: 6.67 or lower]
 c. How would your answer to (b) change if you had financed the initial purchase with only $10,000 of your own
money? [ Ans: $13.33 or lower]
d. What is the rate of return on your margined position (assuming again that you invest $15,000 of your own money)
if Xtel is selling after 1 year at: (i) $22; (ii) $20; (iii) $18? What is the relationship between your percentage return
and the percentage change in the price of Xtel? Assume that Xtel pays no dividends. [Ans: 10.67%, −2.67%,
−16.00%]
e. Continue to assume that a year has passed. How low can Xtel’s price fall before you get a margin call? [ Ans: $7.20
or lower]
8. Suppose you buy a round lot (100 shares) of Francesca Industries stock on 55 percent margin when the stock is selling at
$20 a share. The broker charges a 10 percent annual interest rate, and commissions are 3 percent of the stock value on
the purchase and sale. A year later you receive a $0.50 per share dividend and sell the stock for $27 a share. What is
your rate of return on Francesca Industries? [Ans: 47.14% p.a.]
9. You decide to sell short 100 shares of Charlotte Horse Farms when it is selling at its yearly high of $56. Your broker
tells you that your margin requirement is 45 percent and that the commission on the purchase is $155. While you are
short the stock, Charlotte pays a $2.50 per share dividend. At the end of one year, you buy 100 shares of Charlotte at
$45 to close out your position and are charged a commission of $145 and 8 percent interest on the money borrowed.
What is your rate of return on the investment? [Ans: 12.05%]
10. Two years ago, you bought 300 shares of Kayleigh Milk Co. for $30 a share with a margin of 60 percent. Currently, the
Kayleigh stock is selling for $45 a share. Assuming no dividends and ignoring commissions, compute (a) the annualized
rate of return on this investment if you had paid cash, and (b) your rate of return with the margin purchase. [Ans:
22.47%, 35.4%]
11. Consider the following information:
Stock price per share Rs 60
Margin requirement 50%
Interest rate on margin account 9%
Maintenance margin 30%
Ignoring transaction costs and taxes
a. Assume that an investor takes a long position without using margin. Calculate the rate of return if the stock is sold for Rs
70 per share after one-year.
b. Assume that an investor takes a long position using margin.
(i) Calculate the stock price that will trigger a margin call.
(ii) Calculate the rate of return if the stock is sold for Rs 70 per share after one year.
c. Explain why the rate of return using margin is different from the rate of return without margin.
12. Compute for the following bonds.
a. If a company issued 7 percent coupon, Rs 1,000 par value perpetual bond and investor requires a 9 percent annual
rate of return, what is the value of this bond?
b. Suppose an outstanding bond has 10-years remaining to the maturity with Rs 1,000 par value. The bond is the zero-
coupon bond that pays no coupon payments. If the required return on the bond is 12 percent, what is its value?
c. A company had issued Rs 1,000 par value bond 2 years ago that now has 8 years remaining to maturity from today
and have a coupon interest rate of 7.5 percent. If investor desires a 12 percent yield, what is the value of the bond
today?
13. Compute rate of return on following bonds:
a. A perpetual bond selling at Rs 800. Coupon rate is 10 percent and par value is Rs 1‚000.
b. A zero-coupon bond selling for Rs 400 today and it matures at Rs 1,000 in eight years.
c. The market price is Rs 880 for a 10-year bond (Rs 1,000 par value) that pays 12 percent interest.
14. A bond that matures in 10 years sells for Rs 985. The bond has a face value of Rs 1,000 and a 7 percent annual coupon.
a. What is the bond's current yield?
b. What is the bond's yield to maturity (YTM)?
c. Assume that the yield to maturity remains constant for the next 3 years. What will be the price of the bond 3 years
from today?
15. Assume you have a 1-year investment horizon and are trying to choose among three bonds. All have the same degree of
default risk and mature in 10 years. The first is a zero-coupon bond that pays $1,000 at maturity. The second has an 8%
coupon rate and pays the $80 coupon once per year. The third has a 10% coupon rate and pays the $100 coupon once
per year.
a. If all three bonds are now priced to yield 8% to maturity, what are the prices of (i) the zero-coupon bond; (ii) the
8% coupon bond; (iii) the 10% coupon bond?
b. If you expect their yields to maturity to be 8% at the beginning of next year, what will be the price of each bond?
c. What is your before-tax holding-period return on each bond?
d. If your tax bracket is 30% on ordinary income and 20% on capital gains income, what will be the after-tax rate of
return on each bond?
 e. Recalculate your answers to parts (b)–(d) under the assumption that you expect the yields to maturity on each bond
to be 7% at the beginning of next year.
16. MT Company's stock recently paid a Rs 20 dividend. This dividend is expected to grow by 25 percent for the next 3
years, and then grow forever at a constant rate, g. The current stock price is Rs 588.8. At what constant rate is the stock
expected to grow following year if ks = 12%?
17. A 20-year-maturity bond with par value of $1,000 makes semiannual coupon payments at a coupon rate of 8%. Find the
effective annual yield to maturity of the bond if the bond price is (a) $950 (b) $1,000 (c) $1,050.
18. The Baron Basketball Company (BBC) earned $10 a share last year and paid a dividend of $6 a share. Next year, you
expect BBC to earn $11 and continue its payout ratio. Assume that you expect to sell the stock for $132 a year from
now.
a. If you require 12 percent on this stock, how much would you be willing to pay for it?
b. Given the expected earnings and dividend payments, if you expect a selling price of $110 and require an 8 percent
return on this investment, how much would you pay for the BBC stock?
c. Over the long run, you expect dividends for BBC to grow at 8 percent and you require 11 percent on the stock.
Using the infinite period DDM, how much would you pay for this stock?
19. Just today, Triveni, Inc.'s common stock paid a Rs 12 annual dividend per share and had a closing price of Rs 157.5.
Assume that the market's required return, or capitalization rate, for this investment is 13 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?
20. Investors require a 15% rate of return on ND Company's stock (ks = 15%).
a. What will be ND's stock value if the previous dividend was D 0 = Rs 10 and if investors expect dividends to grow at
a constant compound annual rate of (1) – 5% (2) 0 percent (3) 5% and (4) 10%?
b. Using data from part a, what is the Gordon (constant growth) model value for ND's stock if the required rate of
return is 15% and the expected growth rate is (1) 15% or (2) 20% ? Are these reasonable results? Explain.
c. Is it reasonable to expect that a constant growth stock would have g > ks?
21. NDC's preferred stock is selling for Rs 80 in the market and pays a Rs 12 annual dividend.
a. What is the expected rate of return on the stock?
b. If an investor's required rate of return is 10 percent, what is the value of the stock for that investor? Should the
investor acquire the stock?
22. Consider a price-weighted market index composed of two securities, A and B, with prices of Rs.16 and Rs. 30,
respectively. The index divisor is currently 2.0. calculate the value of the divisor when:
(a) Stock A declares a 5% stock dividend.
(b) Stock B undergoes a 3-for-1 stock split.
(c) Stock A undergoes a 4-for-1 stock split.
[Ans: a = 1.968, b = 1.130, c = 1.478]
23. Consider the three stocks, X, Y, and Z, with the following closing prices on two particular dates:
Stock Date 1 Date 2
X Rs. 16 Rs. 22
Y Rs. 5 Rs. 4
Z Rs. 24 Rs. 30
On date 1, there were 100 shares of stock X, 200 shares of stock Y, and 100 shares of stock Z outstanding.
a. Construct a price-weighted market index using the three stocks X, Y, and Z for dates 1 and 2.
b. Assume that on date 2, stock X splits 4-for-1. What is the price-weighted index’s value on that date?
c. Construct a value-weighted index using the three stocks. Assign the value-weighted index a value of 100 on date 1.
[Ans: a = 15, b = 18.67, c = 18.67]
24. You are given the following information regarding prices for a sample of stocks.
Price
Stock No. of shares
T T+1
A 1,000,000 60 80
B 10,000,000 20 35
C 30,000,000 18 25
a. Construct a price-weighted index for these three stocks, and compute the percentage change in the index for the
period from T to T+1. [Ans: 32.67, 46.67, 42.85%]
b. Construct a value-weighted index for these three stocks, and compute the percentage change in the index for the
period from T to T+1. [Ans: 47.50%]
c. Briefly discuss the difference in the results for the two indices.
25. Given the data in problem 24.
 a. Construct an equal-weighted index by assuming $ 1000 is invested in each stock. What is the percentage change in
the wealth for this period? [Ans: 49.09%]
b. Compute the percentage of price change for each of the stocks in problem 24. Compute the arithmetic mean of these
percentage changes. Discuss how this answer compares to the answer in Part 'a'. [Ans: 33.33%, 75%, 38.89%, avg =
49.07%]
c. Compute the geometric mean of the percentage changes in Part b. Discuss how this result compares to the answer in
Part 'b'. [47.98%]
26. Consider the following data:
Price Shares
A B C A B C
Day 1 12 23 52 500 350 250
Day 2 10 22 55 500 350 250
Day 3 14 46 52 500 175a 250
Day 4 13 47 25 500 175 500b
Day 5 12 45 26 500 175 500
a
Split at close of Day 2.
b
Split at close of Day 3.
a. Calculate a Dow Jones Industrial Average for days 1 through 5. [Ans: Day 1 = 29; Day 2, d=3.7586; Day 3,
d=2.8861; Day 4 = 29.452; Day 5 = 28.759]
b. What effects have the splits had in determining the next day’s index? (Hint: think of the relative weighting of each
stock.)
c. Calculate a Standard & Poor’s Index for days 1 through 5 using a beginning index value of 10. [Ans: I1 = 10,
I2=9.778, I3 = 10.370, I4 = 10.065, I5 = 9.935]
d. Identify what effects the splits had in determining the next day’s index. (Hint: think of the relative weighting of
each stock.)
27. You plan to purchase an Rs 10,000,000 house using a 15-year mortgage obtained from your local bank. The mortgage
rate offered to you is 8.00 percent. You will make a down payment of 20 percent of the purchase price.
(a) Calculate your monthly payments on this mortgage.
(b) Calculate the amount of interest and, separately, principal paid in the 127th payment.
(c) Calculate the amount of interest and, separately, principal paid in the 159th payment.
(d) Calculate the amount of interest paid over the life of this mortgage.
(e) If your bank would have offered you following two options, which option would you choose for financing your
home mortgage?
Option 1: Zero discount point and annual interest rate of 9 percent.
Option 2: Two points and annual interest rate of 8.2 percent.
28. Mr. Ashish Sharma is vice president of Nepal Metal Works Inc. The company is considering to issue bonds to satisfy
part of its financing need for a new venture of Steel Plant, which is going to be launched in Mid-Western Region of
Nepal. He knows that Nepalese Financial Market is sensitive to the price and terms and condition of bond issue. As a
result of this fact, he is reluctant to entertain with new issue. As a financial consultant, he is seeking your help on certain
issues associated with bond contract features, price and yields. You are required to address the following issues on
behalf of Mr. Sharma.
(a) What are the key features of a bond?
(b) What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?
(c) How is the value of any asset whose value is based on expected future cash flows determined?
(d) How is the value of a bond determined? What is the value of a 10-year, Rs 1,000 par value bond with a 10 percent
annual coupon if its required rate of return is 10 percent?
(e) What would be the value of the bond described in part d if, just after it had been issued, the expected inflation rate
rose by 3 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a
premium bond?
(f) What would happen to the bond’s value if inflation fell and k d declined to 7 percent? Would we now have a
premium or a discount bond?
(g) What would happen to the value of the 10-year bond over time if the required rate of return remained (i) at 13
percent, (ii) at 7 percent?
(h) What is the yield to maturity on a 10-year, 9 percent, annual coupon, Rs 1,000 par value bond that sells for Rs
887? That sells for Rs 1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about
the relationship between kd and bond’s coupon rate?
(i) What is the total return, the current yield, and the capital gain yield for the discount bond? (Assume the bond is
held to maturity and the company does not default on the bond.)
 (j) How would the price and yield change in case of part d to I above if interest is paid semiannually?
29. Mr. Ramesh Rijal is the senior vice-president of the Sagarmatha Investment Company, having responsibility for equity
investments. A group of investors has requested that Sagarmatha Investment Company presents an investment seminar
and have asked Mr. Rijal to help them. To illustrate the common stock valuation process, Mr. Rijal has asked you to
analyze the basic issues associated with common stock valuation. On the request of Mr. Rijal, you are to answer the
following questions.
(a) What are the key features of common stock?
(b) Write out a formula that can be used to value any stock, regardless of its dividend pattern. What is a constant
growth stock? How are constant growth stocks valued?
(c) What happens if a company has a constant ‘g’, which exceeds its ‘k s’? Will many stocks have expected g > K s, in
the short run (i.e., for the next few years)? In the long run (i.e., forever)?
(d) Assume that NIC Bank is a constant growth company whose last dividend (D 0, which was paid yesterday) was Rs
20 and whose dividend is expected to grow indefinitely at a 5 percent rate. If stockholders required rate of return
of 10 percent;
1. What is the firm’s expected dividend stream over the next 3 years?
2. What is the firm’s current stock price?
3. What is the stock’s expected value 1 year from now?
4. What are the expected dividend yield, the capital-gains yield; and the total return during the first year?
(e) Now assume that the stock is currently selling at Rs 225. What is the implied required rate of return on the stock?
(f) What would the stock price be if its dividends were expected to have zero growth?
(g) Now assume that NIC expected to experience supernormal growth of 20 percent for the next 3 years, then to return
to its long-run constant growth rate of 5 percent. What is the stock’s value under these conditions?
(h) Suppose NIC is expected to experience zero growth during the first 3 years and then to resume its steady-state
growth of 5 percent in the fourth year. What is the stock’s value now? What is its expected dividend yield and its
capital gains yield in Year 1? In Year 4?
(i) What does market equilibrium mean? Explain.
(j) If equilibrium does not exist, how will it be established? Explain.