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Answers To Assignment 4 PDF
Answers To Assignment 4 PDF
Chapter 11
2. Computation of duration
YTM = 6%
13. The higher duration of the longer term bonds magnifies their sensitivity to interest
rates changes. Thus while it can be true that rates of short-term bonds are more
volatile, but the prices of long term bonds are more volatile.
Scenario II: economic recession with reduced inflation expectations. Interest rates
and bond yields will most likely fall. The callable bond is likely to be called. The
relevant duration calculation for the callable bond is now modified duration to
call. Price appreciation is limited as indicated by the lower duration. The non-
callable bond, on the other hand, continues to have the same modified duration
and hence has greater price appreciation.
14c. The cash flows are uncertain due to the call feature.
20a. This swap could have been made if the investor anticipated a decline in long term
interest rates and an increase in long term bond prices. The deeper discount, lower
coupon bond would provide more opportunity for capital gains, greater call
protection, and greater protection against declining reinvestment rates at a cost of
only a modest drop in yield.
20b. This swap was probably done by an investor who believed the 24 basis point
spread in yield between the two bonds was too narrow, and if it widened to a
more normal level, either a capital gain would be experienced on the T-note or a
capital loss would be avoided on the Phone bond or both. It could also have been
done by an investor expected a decline in interest rates but who also wanted to
maintain the high current coupon income and have the better call protection of the
T-note
20c. This swap would have been made if the investor was bearish on the bond market.
The zero coupon note would be extremely vulnerable to an increase in interest
rates since the YTM is locked in. This is in contrast to the floating rate note where
interest is adjusted by formula each six months to reflect the current return
available.
20d. These two bonds are similar in most respects other than quality and yield. An
investor who believed the yield spread between the Govt and A1 bonds was too
narrow would have made the swap.
20e. ignore
28. The firm should enter a swap in which it pays a 7% fixed rate and receives
LIBOR on $10 million of notional principal. Its total payments will be as follows:
Interest payments on bond -(L +0.01) x 10 million
Net cash flow from swap (-0.07+L) x 10 million
Total 0.08 x 10 million
The interest rate on the synthetic fixed rate loan is 8%
Chapter 13
1. P = 2.1/0.11 = $19.09
2. c
PVGO = $3.33
9a. k = 0.06 + 1.25(0.14-0.06) = 0.16 = 16%
g = 2/3 x 0.09 = 6%
D1 = E0(1+g)(1-retention rate) = 3(1.06)(1/3) = 1.06
P = 1.06/(0.16-0.06) = $10.60
9d. The intrinsic value is $15.85. The value will increase because the firm will pay
out more of its earnings rather than reinvesting them at a poor ROE.
11b. Earnings = $12 per share;dividends = $8 so the dividend payout ratio =8/12 = 2/3
g = ROE x retention rate 0.05 = ROE x (1/3) solving for ROE yields 0.15
or 15%
11c. The price assuming that ROE = k is $120. Therefore the market is paying $40 for
growth opportunities
14b. Using the growth rate of 25%, we can get dividends for years 1-5
D1 = 0.287 (given)
D2 = 0.287 x 1.25 = 0.359
D3 = 0.287 x (1.25)2 =0.449
D4 = 0.287 x (1.25)3 =0.562
D5 = 0.287 x (1.25)4 =0.702
After year 5, the growth is constant 9.3% so we can use the following equation to
estimate the P5 (price in year 5)
P5 = D6/(k-g) = (0.702 x 1.093)/(0.109-0.093) = 0.767/0.016 = 47.9375
Then calculate the present value of dividends D1-D5 and P5 at the required rate of
return of 10.9%
Price today = $30.247
14c. With these new assumptions, Disney stock has an intrinsic value below its market
price. This analysis indicates a sell recommendation. Even though Disney’ s 5-
year growth increases, so does its beta and risk premium.
16. A B
Dividend payout ratio 0.50 0.606
Growth rates 0.07 0.04728
Intrinsic value $33.33 $18.97
Buy stock A since the intrinsic value is higher than the market price.
18a. Stock market return = bond yield + risk prem of stocks over bonds
= 0.09 + 0.05 = 0.14
18d. Good investment since the implied total return is greater than the required rate of
return.
Chapter 14.
1. ROA = return on sales x asset turnover . so the only way Crusty Pie can have an
ROS higher than the industry average and an ROA equal to the industry average
is for its ATO to be lower than the industry average.
11a. ROA =EBIT/Assets = (Net income before tax + interest expense)/avg assets
= (64.8+19.8)/[0.5(544.2+628)] = 0.144 = 14.4%
20. c