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Week 3 5-1 Bond Valuation with Annual payments Jackson Corporation’s bonds have 12 years remaining to maturity.

Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds?

VB = INT*r*[1 -(1+rd)-n]/i + M*(1+rd)-n INT = par value M= maturity value r = coupon rate per coupon payment period rd= effective interest rate per coupon payment period n = number of coupon payments remaining INT = 1000. And, since we are not given the maturity value, we can assume that it is the same as the par value. Therefore, M = 1000. r = .08 i = .09 n = 12 Market price of the bonds=1000*.08 * (1 - 1.09-12)/.09 + 1000*1.09-12 Market price of the bonds = $928.39 5-2 Yield to Maturity for Annual payments Wilson Wonders’s bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 10%. The bonds sell at a price of $850. What is their yield to maturity? Time to maturity = 12 years Par value = $1,000 Coupon rate = 10% Price of the bond = $850 Value of the bond t=1nPar value*Coupon rate1+YTMt+Par value1+YTMn Par value =$1,000 Coupon rate =10% Time to maturity =12 years Yield to maturity =12.475%

5-6 Maturity Risk Premium The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2-year Treasury security yields 6.3%. What is the maturity risk premium for the 2-year security? r = r* + IP + MRP 6.3 = 3 + 3 + MRP 6.4 = 6 + MRP MRP = 6.3 – 6 MRP = 0.3 5.7 The problem asks you to find the price of a bond, given the following facts: N = 16; I/YR = 8.5/2 = 4.25; PMT = 50; FV = 1000. With an excel , solve for PV = $1,085.80 5.13 The problem asks you to solve for the YTM, given the following facts: N = 5, PMT = 80, and FV = 1000. In order to solve for I/YR we need PV. However, you are also given that the current yield is equal to 8.21%. Given this information, we can find PV. Current yield = Annual interest/Current price 0.0821 = $80/PV PV = $80/0.0821 = $974.42. Now, solve for the YTM with excel : N = 5, PV = -974.42, PMT = 80, and FV = 1000. Solve for I/YR = YTM = 8.65%. 6.6 According to the Security Market Line (SML) equation, an increase in beta will increase a company’s expected return by an amount equal to the market risk premium times the change in beta. For example, assume that the risk-free rate is 6 percent, and the market risk premium is 5 percent. If the company’s beta doubles from 0.8 to 1.6 its expected return increases from 10 percent to 14 percent. Therefore, in general, a company’s expected return will not double when its beta doubles. ri = rRF +(rM -rRF)bi = rRF +( rpM) bi If rRF=0.6, rpM =0.4, bi =2, ri =1.4 If rRF=0.6, rpM =0.4, bi =4, ri =2.2 (6-1) Portfolio Beta

An individual has $35,000 invested in a stock with a beta of 0.8 and another $40,000 invested in a stock with a beta of 1.4. If these are the only two investments in her portfolio, what is her portfolio’s beta? Investment Beta $35,000 40,000 $75,000 ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) = 1.12 Bp = 1.12 (6-2) Required Rate of Return Assume that the risk-free rate is 6% and that the expected return on the market is 13%. What is the required rate of return on a stock that has a beta of 0.7? R i = rRF + (Rm – rRF) bi Ri = 6% + (13% - 6%) 0.7 Ri = 10.9 % (6-7) Required Rate of Return Suppose rRF = 9%, rM = 14%, and bi = 1.3. A. What is ri, the required rate of return on Stock i? Ri = rRF + (Rm – rRF) bi Ri = 9% + (14% - 9%) 1.3 Ri = 15.5 % B.Now suppose rRF (1) increases to 10% or (2) decreases to 8%. The slope of the SML remains constant. How would this affect rM and ri? The Rm will increase by 1% if the rRF is increased by 1%. If the rRF is decreased to 8% then the Rm will decrease by 1%. Ri = 10% + (15% - 10%) 1.3 Ri = 16.5% Ri = 8% + (13% -8%) 1.3 Ri = 14.5% C. Now assume rRF remains at 9% but rM (1) increases to 16% or (2) falls to 13%. The slope of the SML does not remain constant. How would these changes affect ri? 0.8 1.4

Ri = rRF + (Rm – rRF) bi Ri = 9% + (16% - 9%) 1.3 Ri = 18.1 % Ri = 9% + (13% - 9%) 1.3 Ri = 14.2%