PG-3 Real and nominal rates of interest Zane Perelli currently has $100 that he can spend today on polo shirts costing $25 each. Alternatively, he could invest the $100 in a risk-free U.S. Treasury security that is expected to earn a 9 jominal rate of interest. The consensus forecast of leading cconomists is a 5% rate of inflation over the coming year. a. How many polo shirts can Zane purchase today? b, How much money will Zane have at the end of 1 year if he forgoes purchasing the polo shirts today? ¢. How much would you expect the polo shirts to cost at the end of 1 year in light of the expected inflation? 4. Use your findings in parts b and ¢ to determine how many polo shirts (fractions are OK) Zane can purchase at the end of 1 year. In percentage terms, how many more or fewer polo shirts can Zane buy at the end of 1 year? ce. What is Zane’s real rate of return over the year? How is it related to the per centage change in Zane’s buying power found in part d? Explain. 6-17 Bond value and changing required returns Midland Urilities has outstanding a bond issue that will ma ¢ to its $1,000 par value in 12 years. The bond has a coupon interest rate of 11% and pays interest annually a. Find the value of the bond if the required return is (1) 11 and (3)8 Use your findings in parts a and b to discuss the relationship between the coupon interest rate on a bond and the required return and the market value of the bond relative to its par value 4d. What two possible reasons could cause the required return to differ from the coupon interest rate? P6-18 Bond value and time—Constant required returns Pecos Manufacturing has just issued a 15-year, 12% coupon interest rate, $1,000-par bond that pays interest annually. The required return is currently 14%, and the company is certain it will remain at 14% until the bond matures in 15 years. a. Assuming that the required return does remain at 14% until maturity, find the value of the bond with (1) 15 years, (2) 12 years, (3) 9 years, (4) 6 years, (5) 3 vears, and (6) 1 year to maturity, ¢. All else remaining the same, when the required return differs from the coupon interest rate and is assumed to be constant to maturity, wh bond value as time moves toward maturity] at happens to theP7-5 P7-11 ‘Common stock valuation—Zero growth Scotto Manufacturing is a mature firm in the machine tool component industry. The firm's most recent common stock divi dend was $2.40 per share. Because of its maturity as well as its stable sales and earn- ings, the firm’s management feels that dividends will remain at the current level for the foreseeable future. a. If the required return is 12%, what will be the value of Scotto’s common stock? b. If the firm’s risk as perceived by market participants suddenly increases, causing the required return to rise to 20%, what will be the common stock value? ‘c. Judging on the basis of your findings in parts a and b, what impact does risk have on value? Explain. Common stock value—Variable growth | Newman Manufacturing is considering a cash purchase of the stock of Grips Tool. During the year just completed, Grips earned $4.25 per share and paid cash dividends of $2.55 per share (Dy = $2.55). Grips’ earnings and dividends are expected to grow at 25% per year for the next 3 years, after which they are expected to grow at 10% per year to infinity. What is the maximum price per share that Newman should pay for Grips if it has a required return of 15% on investments with risk characteristics similar to those of Grips?