Question 3 B (2)

a. The expected cash flow is: (0.5 × $70,000) + (0.5 × 200,000) = $135,000
With a risk premium of 8% over the risk-free rate of 6%, the required rate of return is
14%. Therefore, the present value of the portfolio is:
$135,000/1.14 = $118,421

b. If the portfolio is purchased for $118,421, and provides expected cash inflow of
$135,000, then the expected rate of return [E(r)] is derived as follows:
$118,421 × [1 + E(r)] = $135,000
Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate or return
with the required rate of return.

c. If the risk premium over T-bills is now 12%, then the required return is:
6% + 12% = 18%
The present value of the portfolio is now:
$135,000/1.18 = $114,407

Question 4 A (1)

a.
D1 $8
P0 = = = $160
k − g 0.10 − 0.05

b. The dividend payout ratio is 8/12 = 2/3, so the plowback ratio is b = 1/3. The implied
value of ROE on future investments is found by solving:
g = b × ROE with g = 5% and b = 1/3 ⇒ ROE = 15%

c. Assuming ROE = k, price is equal to:

E 1 $12
P0 = = = $120
k 0.10

Therefore, the market is paying $40 per share ($160 – $120) for growth opportunities.

Question 4 B (1)
 The bond is selling at par value. Its yield to maturity equals the coupon rate, 10%. If the
first-year coupon is reinvested at an interest rate of r percent, then total proceeds at the end of
the second year will be: [$100 × (1 + r)] + $1,100
Therefore, realized compound yield to maturity is a function of r, as shown in the following
table:
r Total proceeds Realized YTM = – 1
8% $1,208 – 1 = 0.0991 = 9.91%
10% $1,210 – 1 = 0.1000 = 10.00%
12% $1,212 – 1 = 0.1009 = 10.09%

Question 4 A (2)

a. k = rf + β [Ε (rM) – rf ] = 6% + 1.25(14% – 6%) = 16%

g = 2/3 × 9% = 6%
D1 = E0(1 + g) (1 – b) = $3(1.06) (1/3) = $1.06

D1 $1.06
P0 = = = $10.60
k − g 0.16 − 0.10

b. Leading P0/E1 = $10.60/$3.18 = 3.33

Trailing P0/E0 = $10.60/$3.00 = 3.53

c.
E1 $3.18
PVGO = P0 − = $10.60 − = −$9.275
k 0.16

The low P/E ratios and negative PVGO are due to a poor ROE (9%) that is less than
the market capitalization rate (16%).

d. Now, you revise b to 1/3, g to 1/3 × 9% = 3%, and D1 to:

E0 × 1.03 × (2/3) = $2.06
Thus: V0 = $2.06/(0.16 – 0.03) = $15.85
 V0 increases because the firm pays out more earnings instead of reinvesting a poor
ROE. This information is not yet known to the rest of the market.

Question 4 B (2)

Current bond price = Sum [{Coupon value/(1+r)^t + Bond Par Value//(1+r)^

a. n = 40; FV = 1000; PV = –950; PMT = 40

You will find that the yield to maturity on a semi-annual basis is 4.26%. This implies
a bond equivalent yield to maturity equal to: 4.26% × 2 = 8.52%
Effective annual yield to maturity = (1.0426)2 – 1 = 0.0870 = 8.70%

b. n = 40; FV = 1000; PV = –1000; PMT = 40

Since the bond is selling at par, the yield to maturity on a semi-annual basis is the
same as the semi-annual coupon rate, i.e., 4%. The bond equivalent yield to maturity is
8%.
Effective annual yield to maturity = (1.04)2 – 1 = 0.0816 = 8.16%

c. n = 40; FV = 1000; PV = –950; PMT = 40

PV = –1050, we find a bond equivalent yield to maturity of 7.52%, or
3.76% on a semi-annual basis.
Effective annual yield to maturity = (1.0376)2 – 1 = 0.0766 = 7.66%