MNGT604: Corporate Governance and Financial Management

Lent term 2022

Practice problems Day 2

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:

----------------------------------

a. PV = = = 311.80
b.
459=1000 /(1+r )10
10 1000
(1+r) =
459
1
10
r=(2 . 179) −1
r=8 . 098 %
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13. The following table summarizes 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?
-----------------------------
 a. Use the following equation:

1
100
1+YTM 1 =( ) 1 ⇒YTM 1 =5 .8 %
94 .52
1
100
1+YTM 2 =( ) 2 ⇒ YTM 2 =5 . 6 %
89 . 68
1
100
1+YTM 3 =( ) 3 ⇒YTM 3=5 . 4 %
85 . 40

...

Maturity (years) 1 2 3 4 5
Price 94.52 89.68 85.40 81.65 78.35
Yield to maturity 5.8% 5.6% 5.4% 5.2% 5.0%

b.

c. The yield curve is downward sloping. Briefly discuss why lower interest
rates help increase economic growth. You may also point out that central
banks do the opposite and increase interest rates to slow down economic
growth and to lower inflation when they are too high (and point out that an
‘overheated’ economy is not conducive to long run stable growth).
------------------------------------------

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?

Using Bond price = F / (1 + r)t +C ({1 – [1/(1 + r)]t } / r )

If F= 1000; C= 70; t=20 and r=.15 we get Bond price = 499.25
As yield rises from 7% to 15%, bond price falls from £1000 to £499.25.

Price and yield move in opposite directions; if interest rates rise, the
price of the bond will fall. This is because the fixed coupon payments
 determined by the fixed coupon rate are not as valuable when interest rates
rise–hence, the price of the bond decreases.

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

Bond Years to 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?

First compute the price (PV) of these 4 bonds at the current YTM and the increased interest
rates:
Using the pond price formula:

Bond A have zero coupon – so only the second part of the above formula should be used.

Bond A’s original price:

1000
PV ( A )0 = =952. 38
1. 05

Prince of Bond A after YT

M increases by 1%:
1000
PV ( A )1 = =943. 40
1. 06
Bond B’s original price:
60 1 1000
PV (B )0 = (1− )+ =959 . 00
.07 (1 .07 ) (1 . 07)5
5

Prince of Bond B after YTM increases by 1%:

60 1 1000
PV (B )1= (1− )+ =920 . 15
. 08 (1. 08 ) (1. 08 )5
5

And so on…

Compute the change percentage:

Years to
Bond maturity Coupon YTM Price0 Price1 % Chg $ Chg
A 1 0% 5% $952.38 $943.40 -0.94% ($8.98)
B 5 6% 7% $959.00 $920.15 -4.05% ($38.85)
C 10 10% 9% $1,064.18 $1,000.00 -6.03% ($64.18)
D 20 0% 8% $214.55 $178.43 -16.83% ($36.12)

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 bond 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?

Solved in excel.

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?

Investors believe the company will eventually start paying dividends (or be sold to
another company).

In general, companies that need the cash will often forgo dividends since dividends are a
cash expense. Young, growing companies with profitable investment opportunities are
one example; another example is a company in financial distress. This question is
examined in depth in a later chapter.

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?

Yes. If the dividend grows at a steady rate, so does the stock price. In other words, the
dividend growth rate and the capital gains yield are the same.
 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?

The constant dividend growth model is:

Pt = Dt × (1 + g) / (R – g)

So the price of the stock today is:

P0 = D0 (1 + g) / (R – g)

P0 = £2.50 (1.05) / (.11 – .05)

P0 = £43.75

We can do find and use the dividend in Year 4, to calculate the price in Year 3.

The dividend at year 4 is D4 = D0 (1 + g)4, so:

P3 = D4 / (R – g)

P3 = D0 (1 + g)4 / (R – g)

P3 = £2.50 (1.05)4 / (.11 – .05)

P3 = £50.65

OR, Simply using the idea in question 5: P 3 = P0 (1 + g)3 = 50.65. This problem is an
illustration of the idea in question 19.

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?

R = Dividend yield + Capital gains yield

R = .041 + .06

R = .1010 or 10.10%

22. What are the assumptions of the dividend discount model? Discuss how
realistic they are?
 One assumption is that dividends remain constant or grows at a constant rate (or has a
predictable pattern).

Some discussion on the signalling effect of dividend changes and other reasons for
stickiness of dividends is required.

When dividends grow at a constant rate, the growth rate should be lower than the required
return on equity. This is true as long term growth rate shouldn’t be expected to be higher
than overall GDP growth (which is lower than required return on equity).

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?

Dividends = $500 × .40 = $200 million

Repurchases = $500 × .20 = $100 million

PV(Future Total Dividends and Repurchases) = ($200 + $100) / (.15 - .03) = $2,500
million

P0 = $2,500 million/125 million shares = $20 per share

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?

D0 3.00
D1
D2
3.30
3.63
} growth rate = 10%
D3 3.8478 } growth rate = 6%

b. What is the present value of the dividend payment expected at the end of
year two?
D2 = 3.63
Discount rate = 12%
PV of D2 =3.63/(1.12)2 = 2.8938

c. What is the expected price of the stock at the end of year two? year three?
 P2= D3 / (r - g)
r=12%, g=6%
P2 = 3.8478/(0.12-0.06)
P2 = 64.13

P3 = D3 (1+g)/ (r - g)
r=12%, g=6%
P3 = 3.8478(1.06)/(0.12-0.06) = 4.078668/0.06
P3 = 67.9778

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

Discount rate = 12%

C.F. D.F. PV of CF
D1 3.30 1.12 2.9464
D2 3.63 1.2544 2.8938
D3 3.85 1.404928 2.7388
P3 67.9778 1.404928 48.3853
P0 56.9643
OR,
C.F. (1+r)^t PV of CF
D1 3.30 1.12 2.9464
D2 3.63 1.2544 2.8938
P2 64.13 1.2544 51.1240
P0 56.9642