INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.

COURSE: FIN-210-50-S13 Finance

SEMESTER: II, 2013

Tutorial 3 – for tutor

INSTRUCTIONS

Students are required to study the following questions and problems indicated and to be
able to solve them by themselves.

Although this is not a required part of a coursework, the purpose of the tutorial is
twofold: to help the student understand the methodology for solving the problems and to
help him/her prepare for the courseworks and/or exams. The utilisation of this resource
can be maximised depending on the time and effort each individual student devotes.

Konstantinos Kanellopoulos
2nd April 2013
Valuation Concepts

Question 1
The rate of return you would get if you bought a bond and held it to its maturity date is
called the bond’s yield to maturity. If interest rates in the economy rise after a bond has
been issued, what will happen to the bond’s price and to its YTM? Does the length of
time to maturity affect the extent to which a given change in interest rates will affect the
bond’s price?

Answer 1
If interest rates increase after a bond has been issued, the market value of the bond will
decrease. Investors can earn the higher yields on alternative investments with similar
risk, and thus they will only buy previously issued bonds if their prices have declined to
the point where the yields to maturity on the outstanding bonds are equal to the yields
on similar risk alternative investments. Everything else equal, the market prices of
bonds with longer terms to maturity will change more than the prices of bonds with
shorter terms to maturity.

Question 2
If you bought a share of common stock, you would typically expect to receive dividends
plus capital gains. Would you expect the distribution between dividend yield and capital
gains to be influenced by the firm’s decision to pay more dividends rather than to retain
and reinvest more of its earnings?

Answer 2
Yes. If a company decides to increase its dividend payout ratio, then the dividend yield
component will rise but the expected long-term capital gains yield will decline. If a
greater percentage of earnings is paid as dividends, less is available for reinvestment in
the firm.

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 Problem 1
The Pennington Corporation issued a new series of bonds on January 1,
1985. The bonds were sold at par ($1,000), have a 12 percent coupon,
and mature on December 31, 2014 (30 years after issue). Coupon
payments are made semi-annually (on June 30 and December 31)

a. What was the YTM of Pennington’s bonds on January 1, 1985?

b. What was the price of the bond on January 1, 1990, five years later, assuming that the
level of interest rates had fallen to 10 percent?

c. Find the current yield and capital gains yield on the bond on January 1, 1990, given
the price as determined in part b.

d. On July 1, 2005, Pennington’s bonds sold for $891.64. What was the YTM at that
date?

e. What were the current yield and capital gains yield on July 1, 2005?

Solution:

f. Whenever bonds are sold at par, the YTM equals the coupon rate and therefore
YTM=12%.

g. The price of the bond on January 1, 1990 (i.e five years later), is the present value of
future cashflows. The period from January 1, 1990 until December 31, 2014, (i.e. the
date of maturity of the series of bonds) is 25 years. However, as coupon payments are
made semi-annually, this will be 25*2=50 periods. Therefore, according to the
equation 5-2b (page 212) of the textbook:

1  (1.051 )50   1 
Vd  60 *    1,000 50 
 0.05   (1.05) 
 60(18.25593)  1,000(0.08720)  1095.36  87.20  1,182.56

However, an exercise of this nature should be less computationally demanding for

courseworks/exams.

h. The current yield is the annual coupon payment divided to the price and therefore:

Current yield = 120 / 1,182.56 = 0.101475 = 10.15%

The capital gains yield is the total yield minus the current yield,

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 i.e. 10% - 10.15% = -0.15%

d. The YTM on July 1, 2005 takes into account the period from July 1, 2005 until
December 31, 2014, where the period is 9 and a half years. However, as coupon
payments are made semi-annually, this will be 9,5*2=19 periods. The approximate yield
to maturity would be given from equation 5-3 (page 211) of the textbook:

1,000  891.64
60  ( )
YTM  19  (60  5.703158) /(927,76)  0.070819  7.08%
2(891.64)  1000
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Therefore, the required rate of return will be 7.08%*2=14.1%

i. The current yield and the capital gains yield are therefore:

Current yield = 120/891.64 = 13.46%

Capital gains yield = 14.1%-13.46%=0.64%

Problem 2
Investors require a 15 percent rate of return on Goulet Company’s
stock (ks = 15%).

a. What will be Goulet’s stock value if the previous dividend was Do = $2 and if
investors expect dividends to grow at a constant compound annual rate of (1) -5
percent, (2) 0 percent, (3) 5 percent, and (4) 10 percent?

b. Using data from part a and the constant growth model, what is the value for Goulet’s
stock if the required rate of return is 15 percent and the expected growth rate is (1) 15
percent or (2) 20 percent? Are these reasonable results? Explain.

c. Is it reasonable to expect that a constant growth stock would have g > ks? Explain.

Solution:

$2(1 - 0.05) $1.90

a. (1) P̂0 = = = $9.50
0.15 + 0.05 0.20

$2
(2) P̂0 = = $13.33
0.15

$2(1 + 0.05) $2.10

(3) P̂0 = = = $21.00
0.15 - 0.05 0.10

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 $2(1  0.10) $2.20
(4) P̂0 = = = $44.00
0.15 - 0.10 0.05

b. (1) P̂0 = $2.30/(0.15 - 0.15) = $2.30/0, which is undefined.

(2) P̂0 = $2.40/(0.15 - 0.20) = $2.30/(-0.05) = -$48, which is nonsense.

These results show that the constant growth formula does not make sense if the required
rate of return is equal to or less than the expected growth rate.

c. No. The results in part b show why.

Problem 3
The risk-free rate of return, kRF, is 11 percent; the required rate of
return on the market, kM, is 14 percent; and Gerlunice Company’s stock
has a beta coefficient, β, of 1.5.

a. Based on the capital asset pricing model (CAPM), what should be the required return
for Gerlunice Company’s stock?

b. If the dividend expected during the coming year, D̂1 is $2.25, and g = 5% and is
constant, at what price should Gerlunice’s stock sell?

c. Now suppose the Federal Reserve Board increases the money supply, causing the
risk-free rate to drop to 9 percent and kM to fall to 12 percent. What would this do to
the price of the stock?

d. In addition to the change in part c, suppose investors’ risk aversion declines; this fact,
combined with the decline in kRF, causes kM to fall to 11 percent. At what price would
Gerlunice’s stock sell?

e. Now suppose Gerlunice has a change in management. The new group institutes
policies that increase the expected constant growth rate to 6 percent. Also, the new
management stabilizes sales and profits, which causes the beta coefficient to decline
from 1.5 to 1.3. Assume that kRF and kM are equal to the values in part d. After all
these changes, what is Gerlunice’s new equilibrium price? (Note: D̂1 goes to $2.27).

Solution:

a. ks = kRF + (kM - kRF)βs = 11% + (14% - 11%)1.5 = 15.5%

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b. P0 = D̂1 / (ks - g) = $2.25/(0.155 - 0.05) = $21.43.

c. ks = 9% + (12% - 9%)1.5 = 13.5%; P0 = $2.25/(0.135 - 0.05) = $26.47

d. ks = 9% + (11% - 9%)1.5 = 12.0%; P0 = $2.25/(0.12 - 0.05) = $32.14

e. According to the change in management: kRF = 9%; kM = 11%; g = 6%, βs = 1.3

ks = kRF + (kM - kRF)βs = 9% + (11% - 9%)1.3 = 11.6%

D0 = $2.25/1.05 = $2.14
P0 = D̂1 /(ks - g) = [$2.14(1.06)]/(0.116 - 0.06) = $2.27/0.056 = $40.54