MNGT604: Corporate Governance and Financial Management

Lent term 2022

Practice problems Day 1 and Day 2

1. Which one of the following comparisons between debt and equity is correct?
a. Both creditors and stockholders are owners of the firm.
b.Both creditors and stockholders vote to elect the board of directors.
c. Stockholders are the owners of the firm but the creditors vote on all major
decisions.
d.The creditors have first claim to the firm’s assets but the stockholders are the
owners.
e. Since the stockholders are the firm’s owners, they have a higher claim to the
firm’s assets than do the creditors.

2. For each of the following compute the missing value

Present Value Years Interest Rate Future Value

£81550 17 12%

14 22% £886073

£221 4 £307

£250 4% £1105

3. You won £ 32,000 in ‘Who Wants to be a Millionaire’ and decided to save enough
so that you are a millionaire when you retire in 40 years. If the current interest rate is
12%, what portion of your prize money will be left with you after you save the
required amount? What if the interest rate you get for your savings is 6%?
Solution:

PV = FV / (1 + r)
£1,000,000/(1.12)40 =

4. You have an investment opportunity in Japan. It requires an investment of $1 million

today and will produce a cash flow of ¥114 million in 1 year with no risk. Suppose
the risk-free interest rate in the United States is 2%, the risk-free interest rate in Japan
is 2%, and the current competitive exchange rate is ¥110 per $1. What is the NPV of
the investment? Is it a good opportunity?

5. Joe just inherited the family business, and having no desire to run the family
business, he has decided to sell it to an entrepreneur. In exchange for the family
business, Joe has been offered an immediate payment of $100,000. Joe will also
receive payments of $50,000 in one year, $50,000 in two years, and $75,000 in three
years. The current market rate of interest for Joe is 6%.
A second entrepreneur approaches Joe and offers him $250,000 today for the
business. Should Joe accept the new entrepreneur's offer or stick with the original
offer of $100,000 and the series of payments over three years? Why?

6. You have been told that you need £21,600 today in order to have £100,000
when you retire 42 years from now. What rate of interest was used in the
present value computation? Assume interest is compounded annually.

7. You just won £25,000 and deposited your winnings into an account that pays
6.2% interest, compounded annually. How long will you have to wait until your
winnings are worth £50,000?

8. Suppose two athletes sign 10-year contracts for £20 million. In one case the
20m will be paid in 10 equal instalments. In the other case the 20 m will be still
 be paid in 10 instalments, but the instalments will increase 5% every year. Who
got the better deal?

Draw the time line:

9. The Bigelow Co. is considering the purchase of some new equipment. The
quote consists of a monthly payment of $3,660 for 36 months at 7.25 percent
interest. What is the purchase price of the equipment?

10. What is the present value of $500 received at the end of each year for six years
starting in year 5 and ending in year 10 if the discount rate is 8 per cent?

11. A company borrow £30,000 3-year loan at 10% from a bank. What is the
amortization schedule for the loan if the company writes a contract to pay a
‘fixed principal’ every year?

What if it chose to make fixed payments?

Bond Valuation

12. Answer the following two questions on zero coupon bonds:

a. Consider a zero-coupon bond with 20 years to maturity. What should be the
market price of this bond if the YTM is 6%?
b. Consider a zero-coupon bond with a $1000 face value and 10 years left
until maturity. If the bond is currently trading for $459, then the yield to
maturity on this bond is closest to:

13. The following table summarizes the prices of various default-risk-free zero-
coupon bonds (expressed as a percentage of face value):

Maturity (years) 1 2 3 4 5
Price 94.52 89.68 85.40 81.65 78.35

a. Compute the yield to maturity for each of the five zero-coupon bonds
b. Plot the zero-coupon yield curve.
c. What can you say about the expectation on the state of the economy in the next
5 years from the yield curve?

14. Suppose you buy a 7% coupon 20-year bond today when it is first issued at par
(£1000). If interest rates suddenly rise to 15% what happens to the value of your
bond? Why?

15. Consider the following four bonds that pay annual coupons:

Years to
Bond maturity Coupon YTM
A 1 0% 5%
B 5 6% 7%
C 10 10% 9%
D 20 0% 8%

What are the percentage change in the price of the four bonds if yield to
maturity increases by 1% as a result of economy wide factors. Which bond is
 most sensitive to interest rate changes and why?

16. Bond X is a premium bond making annual payments. The bond pays 8%
coupon, has YTM of 6% and has 13 years to maturity. Bond Y is a discount
bond making annual payments. This bond pays a 6% coupon, has a YTM of 8%
and also has 13 years to maturity. What are the prices of these bonds today? If
interest rates remain unchanged, what do you expect the prices of these bonds to
be in one year? In three years? In eight years? In twelve, thirteen years? What is
going on here? Illustrate your answers by graphing bond prices versus time to
maturity.

17. Both bond A and bond B have 7% coupons and are priced at par value. Bond A has
three years to maturity whereas bond B has 20 years to maturity. If interest rates
suddenly rise by 2%, what is the percentage change in the price of bonds A and B?
What if interest rates fall by 2% instead? What does this tell you about the interest
rate risks of longer-term bonds?

Stock Valuation

18. Why do people buy shares of stocks in companies that do not pay dividends? Under
what circumstances might a company choose not to pay dividends?

19. In the context of dividend growth model, is it true that the growth rate in
dividends and the growth rate in the price of stocks are identical?

20. Money, Inc., Just paid a dividend of £ 2.50 per share on its stock. The dividends are
expected to grow at a constant rate of 5% per year, indefinitely. If investors require
an 11 % return on Money’s stock, what is the current price? What will be the price in
3 years?
21. Mistakes, Inc., is expected to maintain a constant 6% growth rate in its dividends,
indefinitely. If the company has a dividend yield of 4.1%, what is the required rate of
return on the company’s stock?

22. What are the assumptions of the dividend discount model? Discuss how realistic they
are?

23. The Rufus Corporation has 125 million shares outstanding and analysts expect Rufus
to have earnings of $500 million this year. Rufus plans to pay out 40% of its
earnings in dividends and they expect to use another 20% of their earnings to
repurchase shares. What is the value of a share of Rufus stock if Rufus' equity cost
of capital is 15% and Rufus' earnings are expected to grow at a rate of 3% per year?

24. A stock has just paid a £3.00 dividend. Dividends are expected to grow by 10
percent per year for the next two years, after which they are expected to grow at a
constant rate of 6 percent forever. Investors in this stock require a 12 percent rate of
return.
a. What dividend payment (in pounds) is expected at the end of the third year?

b. What is the present value of the dividend payment expected at the end of year two?

c. What is the expected price of the stock at the end of year two? year three?

d. What pound value will investors place on the stock today?