Chapter-10

Valuation & Rates of return

1. The Lone Star Company has $1,000 par value bonds outstanding at 10 percent
interest. The bonds will mature in 20 years. Compute the current price of the bonds if
the present yield to maturity is (a) 6 percent yield to maturity.

Formula: FV = Face value /par value

1
1- i = interest rate /coupon rate
(1+Y)n FV It =interest payment/coupon
Bond value = It + payment
Y (1+Y)n Y = Yield to maturity
n = no. of periods
 1. Answer:

1
$1,000 FV = Face value
1-
Bond value = $100 (1+.06)20 + i = interest rate = 10%
(1+.06)20 It = interest payment= ($1000*
0.06 0.10) = $100
Y = yield to maturity = 6%
n = no. of periods = 20 years

Bond value = ($100 * 11.470) + $311.82

= $1,147 + $311.82
= $1,458.82
5. Essex Biochemical Co. has a $1,000 par value bond outstanding that pays 15
percent annual interest. The current yield to maturity on such bonds in the market is 17
percent. Compute the price of the bonds for the maturity date of (a) 30 years.
1
1- FV = Future value
(1+.17) 30 $1000 i = interest rate/coupon rate =
Bond value = $150 + 15%
.17 (1+.17) 30 A =It= Annuity= ($1000 * 0.15)
= $150
Ytm = yield to maturity = 17%
n = no. of periods = 30 years

Bond value = $874 + $9.00 = $883

Price of the bond is $883/-
12. Jim Busby calls his broker to inquire about purchasing a bond of Disk Storage Systems. His
broker quotes a price of $1,180. Jim is concerned that the bond might be overpriced based on the
facts involved. The $1,000 par value bond pays 14 percent interest, and it has 25 years remaining
until maturity. The current yield to maturity on similar bonds is 12 percent.
Compute the new price of the bond and comment on whether you think it is overpriced in the
marketplace.
1
1-
(1+.12) 25 $1000
Bond value = $140 +
.12 (1+.12) 25

Bond price = $1,097.83 + $58.82 = $1,156.65

Answer: Broker’s price is at $1,180 is too high compared to $1,156.65 value. It is overpriced.
13. Tom Cruise Lines, Inc., issued bonds five years ago at $1,000 per bond. These bonds had
a 25-year life when issued and the annual interest payment was then 15 percent. This return
was in line with the required returns by bondholders at that point as described next:
 
Real rate of return 4%
Inflation premium 6
Risk premium 5__
Total return 15%
 
Assume that five years later the inflation premium is only 3 percent and is appropriately
reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years
remaining until maturity.

Compute the new price of the bond.

13. Answer:

First calculate the new required rate of return (yield to maturity).

Real rate of return 4%

Inflation premium 3%

Risk premium 5%

Total return 12%

13. Answer:
Then apply this new required rate of return (12%) to find the price of the bond.

1
1-
(1+.12) 20 $1000
Bond value = $150 +
.12 (1+.12) 20

New price of the bond = $1,120.35 + $103.67

= $1,224.02
18. Bonds issued by the Coleman Manufacturing Company have a par value of $1,000,
which of course is also the amount of principal to be paid at maturity. The bonds are
currently selling for $690. They have 10 years remaining to maturity. The annual interest
payment is 13 percent ($130). Compute the yield to maturity.
Answer:

Formula:
Principal payment – Price of the bond
Annual interest payment(It) +
Number of years to maturity
Y=
.6 (price of the bond) + .4 (Principal payment)
$ 1000 - $690
$130 +
10
Y=
.6 ($690) + .4 ($1000)
18.
$390
$130 +
10
Y =
$414 + $400

$169
Y =
$814

= 0.2076 or 20.76 %

Answer: Yield to maturity is 20.76%

21. Heather Smith is considering a bond investment in Locklear Airlines. The $1,000 par
value bonds have a quoted annual interest rate of 11 percent and the interest is paid
semiannually. The yield to maturity on the bonds is 14 percent annual interest. There are 7
years to maturity. Compute the price of the bonds based on semiannual analysis.

Semiannual interest rate = 11% interest / 2 = 5.5% (.055)

Semiannual interest = .055 × $1,000 = $55
Number of periods (n) = 7 × 2 = 14
Yield to maturity (on a semiannual basis) = 14% / 2 = 7%
21.
1
1-
(1+.07) 14 $1000
Bond value = $55 +
.07 (1+.07) 14

Bond value = $481.01 + $387.82 = $868.83

23. The preferred stock of Denver Savings and Loan pays an annual dividend of $5.70. It has a required rate of
return of 6%. Compute the price of the preferred stock.
 Ans:
= $5.70/0.06 = $95

25. X-Tech Company issued preferred stock many years ago. It carries a fixed dividend of $12 per share. With
the passage of time, yields have soared from the original 10% to 17% (yield is the same as required rate of
return).

a) What was the original issue price?

b) What is the current value of the preferred stock?

 Ans:
a) = $12/0.10= $120

 b) = $12/0.17= $70.58

26. Analogue Technology has preferred stock outstanding that pays a $9 annual dividend. It has a price of $76. What
is the required rate of return (yield) on the preferred stock?

 Ans:

 Kp = = $9/$76=11.84%
27. Stagnant Iron and steel currently pays a $12.25 annual cash dividend (D 0). The company plans to maintain the
dividend at this level for the foreseeable future as no future growth is anticipated. If the required rate of return by
common stock holders (Ke) is 18%, what is the price of the common stock?

 Ans: Price of common Stock P0 = = $12.25/0.18= $68.05

28. BioScience Inc. will pay a common stock dividend of $3.20 at the end of the year (D 1). The required rate of
return on common stock (Ke) is 14%. The firm has a constant growth rate (g) of 9%. Compute the current price of
the stock (P0).
 
 Ans: P0 = = $3.20/(0.14-0.09)= $64
30. Maxwell communications paid a dividend of $3 last year. Over the next twelve months, the dividend is
expected to grow at 8 percent, which is the constant growth rate of the firm (g). The new dividend after twelve
months will represent D1. The required rate of return is 14 percent. Compute the price of the stock (P 0).
 
 Ans: P0 =

Given, Growth rate g= 8%

Required rate of return Ke = 14%

D0 = $3,

So, D1 = D0(1+g) = $3(1+0.08) = $3.24

 So, P0 = = $3.24/(14% - 8%) = $54

31. Justine Cement Company has had the following patter of earnings per share over the last five years:

Year EPS
20X1 $5.00
20X2 5.30
20X3 5.62
20X4 5.96
20X5 6.32

The earnings per share have grown at a constant rate and will continue to do so in the future. Dividends
represent 40 percent of earnings. Project earnings and dividends for the next year (20X6).
If the required rate of return (Ke) is 13 percent, what is the anticipated stock price (P0) at the
beginning of 20X6?
Ans: As Dividend is 40% of Earnings
Year EPS Div = EPS*40%
20X1 $5.00 $2
20X2 5.30 2.12
20X3 5.62 2.248
20X4 5.96 2.384
20X5 6.32 2.528

Lets calculate the growth rate (g) of dividend.

g = (Div of a year – Div of previous year)/ Div of previous year
= ($2.12- $2)/2= 0.06= 6%
Or, g= (2.528-2.384)/2.384 = 0.60=6%

Div 20X5 = $2.528

So, Div 20X6 = $2.528(1+0.06) = $ $2.67
 So, P20X6= = $2.67/(13%- 6%) = $38.14
32. A firm pays a $4.80 dividend at the end of year 1 (D1), has a stock price of $80, and a constant growth rate (g) of
5 percent. Compute the required rate of return (Ke).

 Solution:
P0 =

P0 (Ke- g) = D1 (Cross Multiplication)

P0 Ke - P0g = D1
P0 Ke = D1 + P0g

Ke = (D1 + P0g)/ P0

Ke = D1/ P0 + P0g/ P0
Ke = (D1/ P0) + g

Ke = ($4.80/$80) + 0.05

Ke = 0.11 = 11%
33. A firm pays a $1.5 dividend at the end of year 1 (D1), has a stock price of $155 (P0), and a constant growth rate (g) of
10 percent.
a) Compute the required rate of return (Ke).
Indicate whether each of the following changes would make the required rate of return (K e) go up or down. ( Each
question is separate from the others. That is, assume only one variable changes at a time.) No actual numbers are
necessary.
b) The dividend payment increases.
c) The expected growth rate increases
d) The stock price increases.
Solution:
a) Ke = (D1/ P0) + g
Ke = ($1.5/$155) + 0.10
Ke= 0.96% + 10%
Ke=10.96%
b) If the dividend payment increases, required rate of return (K e) will go up.
c) If the expected growth rate increases, required rate of return (K e) will go up.
d) If the stock price increases, required rate of return (K e) will go down.
**Company XYZ paid a dividend of $4.41 in 2013. The growth rate forever is 7%. Requited rate of return is
15%. Calculate the Price of stock at the beginning and end of 2016.
 
Solution:
D2013 = $4.41
g = 7% = 0.07
Ke = 15%
To calculate the price of stock at the beginning of 2016 we need the dividend of 2016 as dividends are always
paid at the end of the year.
So, Div2016 = Div2013 (1+g)3
Div2016 = $4.41 (1 + 0.07)3 = $5.40

 So, P2016beg = = $5.40/ (0.15-0.07) = $67.50

Now, To calculate the price of stock at the end of 2016 (means beginning of 2017) we need the dividend of
2017 as dividends are always paid at the end of the year.

So, Div2017 = Div2013 (1+g)4

Div2017 = $4.41 (1 + 0.07)4 = $5.78

 So, P2016end 0r P2017beg = = $5.78/ (0.15-0.07) = $72.25