Principles of Finance 6th Edition Besley Solutions Manual

Principles of Finance 6th Edition Besley
Solutions Manual
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Principles of Finance 6e Chapter 10
Besley/Brigham
CHAPTER 10
ANSWERS
10-1 The value of any asset is determined by computing the present value of the future cash flows htat
the asset is expected to generate during its useful life.
10-2 The price of the bond will fall and its YTM for other investors will rise if interest rates rise. If the bond
still has a long term to maturity, its YTM will reflect long-term rates. Of course, the bond’s price will
be less affected by a change in interest rates if it has been outstanding a long time and matures
shortly. While this is true, it should be noted that the YTM will increase only for buyers who
purchase the bond after the change in interest rates and not for buyers who purchased previous to
the change.
10-3 The yield to maturity on a perpetual bond—that is, a perpetuity—is equal to the interest payment
divided by the bond’s market value. In other words, rd = INT/Vd.
10-4 The yield to maturity (YTM) represents the average rate of return that an investor will earn if he or
she buys the bond at its current market value and holds it until maturity. The yield to call (YTC)
represents the average rate of return that an investor will earn if he or she buys the bond at its
current market value and holds it until its first call date.
In reality, to earn the YTM or the YTC an investor would have to reinvest each interest payment that
he or she receives at the market rate of return that existed when the bond was purchased.
10-5 True. The value of a share of stock is the PV of its expected future dividends. If the two investors
expect the same future dividend stream and they agree on the stock’s riskiness, then they should
reach similar conclusions as to the stock’s value, regardless of how long each intends to hold the
stock. The value of a stock is not based on how long an investor expects to hold it; rather, the
stock’s value is based on the cash flows that it is expected to generate during its entire life, which
often is considered to be infinite.
10-6 Yes. All else equal, 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, because the
firm’s reinvestment in growth will decline.
10-7 If investors demand a higher required rate of return for investing in AT&T stock, then, all else equal,
the price of the stock must to drop to provide the higher return. In our valuation model, the value for
rs in the denominator would increase, which would cause the result of the computation for the value
of the stock to decrease. If AT&T had to pay a $10 million fine for unfair trade practices, all else
equal, the value of the stock should decrease because (a) the expected future cash flows of AT&T
will decrease due to the unexpected cash outflow, and (b) investors might now demand a higher
rate of return for investing in AT&T.
10-8 Investors who have sufficient income to support their chosen life styles often purchase stocks that
pay little or no dividends so that they do not have to pay higher taxes in the current period. Such
investors prefer to delay taxes until later in life, so they tend to purchase stocks with high capital
gains rather than high dividend yields. Investors who depend on investment income to support their
life styles tend to purchase income-producing stocks—that is, stocks that pay high, fairly constant
dividends.
10-1
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Chapter 10 Principles of Finance 6e
Besley/Brigham
People in high income tax brackets will be more inclined to purchase ”growth” stocks to take the
capital gains and thus delay the payment of taxes until a later date.
10-9 The par value of a common stock has no direct relationship to its market value. The market value is
based on the cash flows the investment is expected to generate in the future. Often the dividend
that preferred stockholders receive is stated as a percent of the stock’s par value. All else equal, the
higher the percent dividend, the higher the dollar dividend, and thus the higher the stock’s price will
be.
10-10 Effect on Value

a. Investors require a higher rate of return to buy the stock. –
(The price of the stock must decrease so that the return that is
expected by new investors equals the higher rate of return.)
b. The company increases dividends. +

(The stock’s expected future cash flows increase.)
c. The company’s growth rate increases. +

(The stock’s expected future cash flows increase.)
d. Investors become more risk averse. –

(Investors will increase the required rate of return, which will
decrease the value of the stock. See part a.)
You can see the mathematical effects of these changes by examining Equation 10-9. Using the
example discussed in the chapter, change each variable in the equation and observe the effect on
the value of the stock.
10-11 The general principle behind valuing a real asset is the same as for a financial asset. The principal
difference is that it probably is more difficult to estimate values for the needed inputs to the
valuation model—future cash flows and the required rate of return. We discuss this concept in detail
later in the book.
________________________________________________________
SOLUTIONS
10-1 Calculator solution: Input N = 12, I/Y= 6, PMT = 40, and FV = 1,000, compute PV = -832.32.
 1 − 1 12   1 
Vd = 40 
(1.06 ) 
+ 1,000  12 
 0.06   (1.06 ) 
 
= 40(8.38384 ) + 1,000( 0.49697 ) = 335.3538 + 496.97 = 832.32
10-2 Calculator solution: Input N = 12, I/Y= 7, PMT = 50, and FV = 1,000, compute PV = -841.15.
 1 − 1 12   1 
Vd = 50 
(1.07 ) 
+ 1,000  12 
 0.07   (1.07 ) 
 
= 50(7.94269 ) + 1,000( 0.444012 ) = 397.1345 + 444.012 = 841.15
10-2
Besley/Brigham
10-3 a. The bonds now have n = 8 x 2 = 16 interest payments remaining until maturity, and their value
is calculated as follows:
 1 − 1 16   1 
Vd = 50 
(1.03 ) 
+ 1,000  
 0.03  16
 (1.03 ) 
 
= 50(12.61102 ) + 1,000( 0.62317 ) = 628.05 + 623.17 = 1,251.22
Calculator solution: Input N = 16, I/Y= 3, PMT = 50, and FV = 1,000, compute PV = -1,251.22.
b. The price of the bond will decline from $1,251.22 toward $1,000, hitting $1,000 (plus accrued
interest) at the maturity date eight years (16 six-month periods) from now (assuming the firm
does not default).
10-4 a. Calculator solution: Input N = 20, I/Y= 5, PMT = 35, and FV = 1,000, compute PV = -813.07.
 1 − 1 20   1 
Vd = 35 
(1.05 ) 
+ 1,000  10 
 0.05   (1.05 ) 
 
= 35(12.46221) + 1,000(0.376889 ) = 436.1774 + 376.889 = 813.07
b. The price of the bond will increase from $813.77 toward $1,000, hitting $1,000 (plus accrued
interest) at the maturity date (assuming the firm does not default).
D $6.80
10-5 P̂0 = = = $85
r ps 0.08
D $16.50
10-6 P̂0 = = = $150
r ps 0.11
10-7 Dividend = 0.10($80) = $8
D $8.00
P̂0 = = = $100
r ps 0.08
10-8 D̂1 = $5(1.04 ) = $5.20
D̂1 D0 (1+ g) $5.20

P̂0 = = = = $65
rs - g rs - g 0.12 − .04
10-9 D̂1 = $1.50(1.02) = $1.53
10-3
Besley/Brigham
D̂1 D0 (1+ g) $1.53

P̂0 = = = = $15.30
rs - g rs - g 0.12 − .02
10-10 The first step is to solve for g, the unknown variable, in the constant growth equation. Because
D̂ 1 is unknown but D0 is known, substitute D0(1 + g) as follows:
D̂1 D (1 + g)
P̂0 = P0 = = 0
rs − g rs − g
$2.40(1 + g)
$36 =
0.12 − g
Solving for g, we find the growth rate to be 5 percent:
$4.32 – $36g = $2.40 + $2.40g

$38.4g = $1.92
g = 0.05 = 5%.
The next step is to use the growth rate to project the stock price five years hence:
D 0 (1 + g) 6
P̂5 =
rs − g
$2.40(1.05) 6 $3.2162
= = = $45.95
0.12 − 0.05 0.07
Alternative solution: Because the company will grow at a constant 5 percent, its stock value will
increase at this same rate. As a result, we have
P̂5 = P0 (1 + g)n = $36(1.05)5 = $36(1.27628) = $45.95
Therefore, Ewald Company’s expected stock price five years from now, P̂5 , is $45.95.
D̂1 D0 (1+ g) $5[1+ (-0.05)] $4.75

10-11 P̂0 = = = = = $23.75
rs - g rs - g 0.15 - (-0.05) 0.20
D̂1 D0 (1.04 )
10-12 P̂0 = = = $28.00
r s - g 0.11 - 0.04
D̂1 = P̂0 (rs − g)= $28( 0.07 ) = $1.96
10-4
Besley/Brigham
1 − 1 N  M
(1+r )
10-13 a. Vd = PMT  +
 r  (1 + r )N
 
(1) 5%: Bond L: Vd = $100(10.37966) + $1,000(0.48102) = $1,518.99

Bond S: Vd = ($100 + $1,000)(0.95238) = $1,047.62
(2) 7%: Bond L: Vd = $100(9.107914) + $1,000(0.362446) = $1,273.24

Bond S: Vd = ($100 + $1,000)(0.934579) = $1,028.04
(3) 11%: Bond L: Vd = $100(7.19087) + $1,000(0.209004) = $928.09

Bond S: Vd = ($100 + $1,000)(0.900901) = $990.99
Calculator solutions:
(1) 5%: Bond L: Input N = 15, I/Y= 5, PMT = 100, and FV = 1000; compute PV = -1,518.98
Bond S: Change N = 1; compute PV = -1,047.62
(2) 7%: Bond L: Input N = 15, I/Y= 7, PMT = 100, and FV = 1000; compute PV = -1,273.24
Bond S: Change N = 1; compute PV = -1,028.04
(3) 11%: Bond L: Input N = 15, I/Y= 11, PMT = 100, and FV = 1000; compute PV = -928.09
Bond S: Change N = 1; compute PV = -990.99
b. Think about a bond that matures in one month. Its present value is influenced primarily by the
maturity value, which will be received in only one month. Even if interest rates double, the price
of the bond still will be close to $1,000. The value of a one-year bond would fluctuate more than
the value of a one-month bond’s value because of the difference in the timing of receipts.
However, its value would still be fairly close to $1,000 even if interest rates doubled. A
long-term bond paying semiannual coupons, on the other hand, will be dominated by distant
receipts, receipts that are multiplied by 1/(1 + r d)N, and if rd increases, these multipliers will
decrease significantly. Another way to view this problem is from an opportunity point of view. A
one-month bond can be reinvested at the new rate very quickly, and hence the opportunity to
invest at this new rate is not lost; however, the long-term bond locks in returns, which could be
subnormal, for a long period of time.
10-14 a. Year Dividend

1 $2.100 = $2.000(1.05)
2 2.205 = $2.100(1.05)
3 2.315 = $2.205(1.05)
You will also receive the market price of the stick when you sell it in Year 3. The market price of
the stock in Year 3 will be:
4
D̂4 D0 (1+ g) $2(1.05)4 $2.431
P̂3 = = = = = $34.73
rs - g rs - g 0.12 - 0.05 0.07
D̂1 D0 (1+ g) $2(1.05) $2.10

b. P̂0 = = = = = $30.00
rs - g rs - g 0.12 - 0.05 0.07
10-5
Besley/Brigham
10-15 D0 = $1
r = 7% + 6% = 13% = dividend yield + g
g1 = 50%
g2 = 25%
gnorm = 6%
D̂ 1 =$1.000(1.50) = $1.5000
D̂ 2 =$1.500(1.25) = $1.8750
D̂ 3 =$1.875(1.06) = $1.9875
rs = 13%
g1 = 50%
0
g2 = 25%
1
gnorm = 6%
2 3
…
1.327 1.50 1.875
+ 28.393 = 1.9875/(0.13 – 0.06)
23.704 = 30.268
25.031
Nonconstant growth ends at the end of Year 2, thus P̂2 can be computed using the constant growth
dividend discount model:
D̂ 3 $1.9875
P̂2 = = = $28.393
rs − g n 0.13 − 0.06
The current price is the present value of D̂ 1 , D̂ 2 , and P̂2 :
$1.50 $1.875 + $28.393

P̂0 = +
(1.13 )1 (1.13 ) 2
= $1.50( 0.88496 ) + $30.268( 0.78315 )

= $1.327 + $23.704
= $25.03
10-16 Calculate the dividend stream, and place them on a cash flow time line. Also, calculate the price of
the stock at the end of the supernormal growth period, and include it, along with Year 5 dividend.
D0 = D̂1 = D̂ 2 = 0
D̂ 3 = 1.00
D̂ 4 = 1.00(1.5) = 1.50
D̂ 5 = 1.00(1.5)2 = 2.25
D̂ 6 = 2.25(1.08) = 2.43
D̂ 6 $2.43
P̂5 = = = $34.7143
rs − g n 0.15 − 0.08
10-6
Besley/Brigham
0
rs = 15%
1 2 3 4 5 6
…
g1 = 50% g2 = 50% gnorm = 8%
0.6575 1.00 1.50 2.25
0.8576 + 34.7143 = 2.43/(0.15 – 0.08)
18.3778 = 39.9643
19.8929
$0 $0 $1.00 $1.50 $2.25 + $34.7143

P̂0 = 1
+ 2
+ 3
+ 4
+
(1.15 ) (1.15 ) (1.15 ) (1.15 ) (1.15 ) 5
= $1.00( 0.65752 ) + $1.50( 0.57175 ) + $36.9643( 0.49718 )

= $0.6575 + $0.8576 + $18.3779
= $19.89
With a calculator, enter the cash flows as shown on the time line into the cash flow register, enter
the required rate of return as I/Y= 15, and then find the value of the stock using the NPV
calculation. Be sure to enter CF0 = 0, or else your answer will be incorrect.
CF0 = 0; CF1-2 = 0; CF3 = 1.0; CF4 = 1.5; CF5 = 36.9643; I/Y= 15%.
With these cash flows in the cash flow register, press NPV to get the value of the stock today:
NPV = $19.89.
$2.50 $3.00 $4.00

10-17 PV of dividends for Year 1 - Year 3 = + +
(1.14 )1 (1.14 ) 2 (1.14 ) 3
= $2.50(0.87719) + $3.00(0.76947) + $4.00(0.67497) = $7.20
Calculator solution: Input 0, 2.50, 3.00, and 4.00 into the cash flow register, input I/Y= 14; compute
PV = $7.20.
$4(1+ 0.04) $4.16

P̂3 = = = $41.60
0.14 - 0.04 0.10
$41.60
P̂0 = PV of dividends + PV of price in Year 3 = $7.20 + = $35.28
(1.14 ) 3
10-18 a. (1) Calculate the PV of the dividends paid during the supernormal growth period:
D̂ 1 = $1.1500(1.15) = $1.3225
D̂ 2 = $1.3225(1.15) = $1.5209
D̂ 3 = $1.5209(1.13) = $1.7186
10-7
Besley/Brigham
PV of D̂ = $1.3225(0.89286) + $1.5209(0.79719) + $1.7186(0.71178)

= $1.1809 + $1.2124 + $1.2233
= $3.6167 ≈ $3.62.
(2) Find the PV of Snyder’s stock price at the end of Year 3:
D̂ 4 D̂ (1 + g)
P̂3 = = 3
rs − g rs − g
$1.7186(1.06)
= = $30.36
0.12 − 0.06
PV of P̂3 = $30.36(0.71178) = $21.61
(3) Sum the two components to find the value of the stock today:
P̂0 = $3.62 + $21.61 = $25.23.
Alternatively, the cash flows can be placed on a time line as follows:
0 12% 1 2 3 4
g = 15% g = 13% g = 6%
1.3225 1.5209 1.7186
P̂3 = 30.3617 = $1.8217/(0.12 – 0.06)
32.0803
Enter the cash flows into the cash flow register, I = 12, and press the NPV key to obtain P 0
= $25.23.
b. P̂1 = $1.5209(0.89286) + $1.7186(0.79719) + $30.36(0.79719)

= $1.3580 + $1.3701 + $24.2027
= $26.9308 = $26.93.
(Calculator solution: $26.93.)
P̂2 = $1.7186(0.89286) + $30.36(0.89286)

= $1.5345 + $27.1072
= $28.6418 = $28.64.
(Calculator solution: $28.64.)
c. Dividend Capital Gains Total

Year Yield + Yield = Return
$1.3225 $26.93 - 25.23
1  5.242% +  6.738% = 12%
$25.23 $25.23
$1.5209 $28.64 - 26.93
2  5.648% +  6.350% = 12%
$26.93 $26.93
$1.7186 $30.36 - 28.64
3  6.000% +  6.000% = 12%
$28.64 $28.64
10-8
Besley/Brigham
10-19 Calculator solution: Input N = 20, PV = -598.55, PMT = 25, and FV = 1,000, compute I/Y = 6.0 per
six months.
YTM = 6.0% x 2 = 12.0%
10-20 Calculator solution: N = 5, PV = -567.44, PMT = 0, and FV = 1,000; I/Y = 12.0%
10-21 Calculator solution: Input N = 16, PV = -902.81, PMT = 30, and FV = 1,000, compute I/Y = 3.83 per
six months.
YTM = 3.823% x 2 = 7.646%
1 − 1 N  M
(1+r )
10-22 Vd = PMT  + ; r = YTM
 r  (1 + r )N
 
M = $1,000
INT = 0.095($1,000) = $95
N = 28 years
Vd = $1,165.75
Calculator solution: Input N = 28, PV = -1,165.75, PMT = 95, FV =1000; compute I/Y = 8.00% =
YTM
10-23 a. M = $1,000 = FV on the calculator

INT = 0.09($1,000) = $90 = PMT on the calculator
N=4
(1) Vd = $829 = PV
Calculator solution: YTM = 14.99%
(2) Vd = $1,104 = PV
Calculator solution: YTM = 6.00%
1 − 1 N  M 1 − 1 4  1,000
Vd = PMT  + = 90  +
(1+ r ) (1.12 )
b.
 r  (1 + r ) N  0.12  (1.12 ) 4
   
= 90(3.03735) + 1,000(0.63552) = 908.88
Calculator solution: Enter I/Y = 12, N = 4, FV = 1,000, and PMT = 90; compute PV = -908.88.
Thus, if the bond is selling at a price of $829, it would be a bargain.
10-24 Because it was a new issue, Robert paid $1,000 for the bond he purchased.
(1) Return = [($925 - $1,000) + $80]/$1,000 = 0.005 = 0.5%

10-9
Besley/Brigham
(2) Current yield = $80/$1,000 = 0.08 = 8.0%
Capital gains = (-$75)/$1,000 = -0.075 = -7.5%
Total return = Current yield + Capital gains = 8.0% - 7.5% = 0.5%
10-25 Vd = INT/rd; therefore, rd = INT/Vd.
INT = 0.08($1,000) = $80
(a) rd = $80/$600 = 13.3%
(b) rd = $80/$800 = 10.0%
(c) rd = $80/$1,000 = 8.0%
(d) rd = $80/$1,500 = 5.3%
10-26 Bonds: Price $897.40, 20 years, PMT = $40 per 6 mos., N = 40 periods, M = $1,000
Preferred: $2/quarter forever, $95/share
Bonds: Selling at a discount, so rd > Coupon.
With a calculator, input N = 40, PV = -897.40, PMT = 40, and FV = 1000; compute I/Y = 4.563 =
periodic rate (per six months)
rEAR = (1.04563)2 – 1 = 9.33%, YTM = 9.33%.
Preferred: $2/$95 = periodic (quarterly) rate of 2.11%.
rEAR = (1.0211)4 – 1 = 8.69%.
Thus, the bond has a higher EAR.
10-27 The bond is selling at a large premium, which means that its coupon rate (C) is much higher than
the going market rate of interest (rd).
With a calculator, enter N = 60, PV = -1,353.54, PMT = 70, and FV = 1,000; compute I/Y = 5.10
The actual periodic rate is 5.10 percent per six months, so the nominal YTM is 2 x 5.10% = 10.2%.
This would be close to the going rate, and it is about what Tapely would have to pay on new bonds.
10-28 Total dollar return per share = ($21 - $15) + $0.90 = $6.90
Rate of $21 - $15 $0.90 $6.90 Capital Dividend

= + = = 0.40 + 0.06 = 0.46 = 46.0% = +
return $15 $15 $15 gains yield
10-10
Besley/Brigham
10-29 Total dollar return per share = ($27.50 - $25.00) + ($1.25) = $3.75
Rate of $27.50 - $25.00 $1.25 $3.75 Capital Dividend

= + = = 0.10 + 0.05 = 0.15 = 15.0% = +
return $25.00 $25.00 $25 gains yield
D D $12.60
10-30 P̂0 = rps = = = 0.12 = 12.0%
r ps P̂0 $105.00
D D 0.08($100 ) $8
10-31 P̂0 = rps = = = = 0.05 = 5.0%
r ps P̂0 $160.00 $160
Because g = 0 for preferred stock, Total return = Dividend yield + 0. Thus, Dividend yield = 5%.
10-32 a. g = $1.1449/$1.07 - 1.0 = 7%.
Calculator solution: Input N = 1, PV = -1.07, and FV = 1.1449; compute I/Y= 7.00
or Input N = 2, PV = -1.07, and FV = 1.2250; compute I/Y= 7.00
b. Dividend yield = $1.07/$21.40 = 5%.
c. r̂ s = D̂ 1 /P0 + g = $1.07/$21.40 + 7% = 5% + 7% = 12%.
1 − 1 N  M
(1+r )
10-33 Vd = PMT  + ; r = YTM
 r  (1 + r )N
 
a. M = $1,000
INT = $40 per six months
N = 12
Vd = $889
Calculator solution: Input N = 12, PV = -889, PMT = 40, FV =1000; compute I/Y= 5.27% per six
months
YTM = 5.27% x 2 = 10.54%
b. M = $1,000
INT = $40 per six months
N = 10
Vd = $1,042
Calculator solution: Input N = 10, PV = -1042, PMT = 40, FV =1000; compute I/Y= 3.5% per six
months
YTM = 3.495% x 2 = 6.99% ≈ 7.0%
10-11
Besley/Brigham
c. Return = ($1,042 - $889)/$889 + [2($40)]/$889
= 0.1721 + 0.0900 = 17.21% + 9.00% = 26.21%
= Capital gains yield + Current yield
1 − 1 N  M 1 − 1  1,000
Vd = PMT  +  +
(1+r ) (1.035 )N
10-34 = 40 = 274.96 + 759.41 = 1,034.37
 r  (1 + r ) N  0.035  (1.035 ) 8
   
Calculator solution: Input N = 8, I/Y= 3.5, PMT = 40, FV =1000; compute PV = -1,034.37
Return = ($1,034.37 - $1,042)/$1,042 + [2($40)]/$1,042 = -0.007 + 0.077
= -0.7% + 7.7% = 7.0%
= Capital gains yield + Current yield
10-35 a. This is not necessarily true. Because G plows back two-thirds of its earnings, its growth rate
should exceed that of D, but D pays higher dividends ($6 versus $2). We cannot say which
stock should have the higher price.
b. Again, we just do not know which price would be higher.
c. This is false. The change in rs would have a greater effect on G— its price would decline
more.
d. The total expected return for D is r̂D = D̂ 1 /P0 + g = 15% + 0% = 15%. The total expected
return for G will have D̂ 1 /P0 less than 15 percent and g greater than 0 percent, but
r̂G should be neither greater nor smaller than D’s total expected return, 15 percent, because
the two stocks are stated to be equally risky.
e. We have eliminated a, b, c, and d, so e should be correct. On the basis of the available

information, D and G should sell at about the same price, $40; thus, r̂ s = 15% for both D
and G. G’s current dividend yield is $2/$40 = 5%. Therefore, g = 15% – 5% = 10%.
INT $100
10-36 a. Vd = = = $1,250
rd 0.08
INT $100
b. Vd = = = $833.33
rd 0.12
INT $100
c. Vd = = = $1,000 = par value
rd 0.10
d. (1) Assuming annual interest payments: at 8%: V d = $100(9.81815) + $1,000(0.21455) =

981.81 + $214.55 = $1,196.36
10-12
Besley/Brigham
Calculator solution: Input N = 20, I/Y = 8, PMT = 100, and FV = 1000; compute PV =
-1,196.36.
(2) At 12%: Vd = $100(7.46944) + $1,000(0.10367) = $746.94 + $103.67 = $850.61
Calculator solution: Change I/Y = 12; compute PV = $850.61
(3) At 10%: Vd = $100(8.51356) + $1,000(0.14864) = $851.36 + $148.64 = $1,000
Calculator solution: Change I/Y = 10; compute PV = $1,000.00
If the bonds are selling at a premium, the value of the 20-year bond will be less than the value
of the perpetuity, whereas the perpetuity will have a lower value if the bonds are selling at a
discount. The value of the shorter, 20-year bond fluctuates less than the longer-term, perpetual
bond because the value of the perpetuity’s distant coupon payments fluctuate significantly as
the yield changes.
10-37 a. The coupon interest is $50 = 0.05($1,000) per year, and the original yield to maturity was 5.0
percent; so both bonds would have sold for par, or for $1,000, at the time of issue. To see this,
compute the value of the IBM bond:
10 $50 $1,000
VIBM =  (1.05 ) + (1.05 )
t =1
t 10
 1 − 1 10   1 
= $50 
(1.05 ) 
+ $1,000  
 0.05  10
   (1.05 ) 
= $50(7.72173 ) + $1,000(0.61391) = $1,000
Calculator solution: Input N = 10, FV = 1,000, PMT = 50, and I/Y= 5; compute PV = -1,000
b. On January 1, 2012, the IBM bond had a remaining life of nine9 years. Thus, its value is
calculated as follows:
9 $50 $1,000
VIBM =  (1.06 )
t =1
t
+
(1.06 )9
=$50(6.80169 ) + $1,000(0.591898 ) = $931.98
With a calculator, enter I/Y= 6, N = 9, FV = 1000 and PMT = 50; compute PV = -931.98
On January 1, 2007, the Microsoft bond had a remaining life of 19 years. Thus, its value is
calculated as follows:
19 $50 $1,000
VM icrosoft =  (1.06 )
t =1
t
+
(1.06 )19
=$50(11.158116 ) + $1,000(0.330513 ) = $888.42
With a calculator, simply change N to 19; compute PV = -888.42
10-13
Besley/Brigham
c. The capital gains yields for the bonds are:
$931.98 - $1,000
Capital gains IBM = = − 0.068 = −6.8%
$1,000
$888.42 - $1,000
Capital gains M icrosoft = = − 0.112 = −11.2%
$1,000
d. The current yield for both bonds was $50/$1,000 = 0.05 = 5.0%
e. Total returnIBM = 5% + (-6.8%) = –1.8%
Total returnMicrosoft = 5% + (-11.2%) = –6.2%
f. The IBM bond, which has the shorter term to maturity, lost less than the Microsoft bond. The
price of the shorter-term bond changes less with each change in interest rates (yields), so when
the market rates increase, the prices for shorter-term bonds will decrease less than for longer-
term bonds.
g. On January 1, 2020, the IBM bond will have a remaining life of four years. Thus, its value will
be:
4 $50 $1,000
VIBM = 
t =1 (1.06 )
t
+
(1.06 )4
=$50( 3.46511) + $1,000(0.792094 ) = $965.35
With a calculator, enter I/Y= 6, N = 4, FV = 1000 and PMT = 50; compute PV = $965.35
On January 1, 2020, the Microsoft bond will have a remaining life of 14 years, and its value will
be:
14 $50 $1,000
VM icrosoft = 
t =1 (1.06 )
t
+
(1.06 )14
=$50( 9.294984 ) + $1,000(0.442301) = $907.05
With a calculator, simply change N to 14; compute PV = $907.05
At maturity, the values of both bonds must equal $1,000, because this is the face value of both.
So, if market rates do not change, as each bond gets closer to its maturity date, its market
value will approach its $1,000 face value. The closer the maturity date, the quicker the market
value will approach its face value (the value of the IBM bond will increase more than the
Microsoft bond during the next six years because its maturity date is closer).
$2(1 - 0.05) $1.90

10-38 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
10-14
Besley/Brigham
$2(1 + 0.10) $2.20

(4) P̂0 = = = $44.00
0.15 - 0.10 0.05
b. (1) P̂0 = [$2(1.15)]/(0.15 - 0.15) = $2.30/0, which is undefined.
(2) P̂0 = [$2(1.20)]/(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.
$2.25(1.05 ) $2.3625
10-39 a. P̂0 = = = $22.50
0.155 - 0.05 0.105
$2.25(1.05 ) $2.3625
b. P̂0 = = = $27.79
0.135 - 0.05 0.085
$2.25(1.05 ) $2.3625
c. P̂0 = = = $33.75
0.12 - 0.05 0.07
$2.25(1.06 ) $2.385
d. P̂0 = = = $42.59
0.116 - 0.06 0.056
10-40 a. D̂ t = D0(1 + g)t

D̂ 1 = $1.75(1.15)1 = $2.0125
D̂ 2 = $1.75(1.15)2 = $1.75(1.3225) = $2.3144
D̂ 3 = $1.75(1.15)3 = $1.75(1.5209) = $2.6615
D̂ 4 = $1.75(1.15)4 = $1.75(1.7490) = $3.0608
D̂ 5 = $1.75(1.15)5 = $1.75(2.0114) = $3.5199
b. Step 1
5
ˆt
PV of
dividends
=  (1+Dr )
t=1 s
t
$2.0125 $2.3144 $2.6615 $3.0608 $3.5199

= 1
+ 2
+ 3
+ 4
+ = $9.4787
(1.12) (1.12) (1.12) (1.12) (1.12)5
With a calculator, enter the dividends in the order shown above, enter the required rate of
return as I/Y= 12, and then find the value of the stock using the NPV calculation. Be sure to
enter CF0 = 0, or else your answer will be incorrect.
10-15
Besley/Brigham
CF0 = 0; CF1 = 2.01; CF2 = 2.31; CF3 = 2.66; CF4 = 3.06; CF5 = 3.52; I/Y= 12%.
With these cash flows in the cash flow register, press NPV to get the value of the stock today:
NPV = $9.4787.
Step 2
Dˆ ˆ (1 + g)
P̂5 = 6
= D5
rs - gn rs - gn
$3.5199(1.05) $3.6959
= = = $52.7981
0.12 - 0.05 0.07
This is the price of the stock five years from now. The PV of this price, discounted back five
years, is as follows:
$52.7981
PV of Pˆ5 = = $52.80(0.56743) = $29.9591
(1.12)5
Step 3
The price of the stock today is as follows:
P0 = PV dividends Years 1-5 + PV of P5 = $9.4787 + $29.9591 = $39.4378  $39.44
This problem could also be solved by substituting the proper values into the following equation:
 D̂6   1 
5 t
D0 (1+ gs )
P0 = t =1 (1+ r s )t
+
 n

 s 

 r s - g   (1 + r )5 
Calculator solution: Input 0, 2.0125, 2.3144, 2.6615, 3.0608, 56.3180 = (3.5199 + 52.7981) into
the cash flow register, and input I/Y = 12; compute PV = $39.44.
c. Year 1
D̂ 1 /P0 = $2.01/$39.43 = 5.10%

Capital gains yield = 6.90*
Expected total return = 12.00%
Year 5
D̂ 6 /P5 = $3.70/$52.80 = 7.00%
Capital gains yield = 5.00 = gnorm
Expected total return = 12.00%
*We know that r is 12 percent, and the dividend yield is 5.10 percent; therefore, the capital
gains yield must be 6.90 percent.
The main points to note here are as follows:
(1) The total yield is always 12 percent (except for rounding differences).
(2) The capital gains yield starts relatively high and then declines as the supernormal growth
10-16
Besley/Brigham
period approaches its end. The dividend yield rises.

(3) After 12/31/14, the stock will grow at a 5 percent rate. The dividend yield will equal 7
percent, the capital gains yield will equal 5 percent, and the total return will be 12 percent.
d. Because Swink’s supernormal and normal growth rates are lower, the dividends and, hence,
the present value of the stock price will be lower. The total return from the stock will still be 12
percent, but the dividend yield will be larger and the capital gains yield will be smaller than they
were with the original growth rates. This result occurs because we assume the same last
dividend but a much lower current stock price. The stock price would be $31.50.
e. As the required return increases, the price of the stock goes down, but both the capital gains
and dividend yields increase initially. Of course, the long-term capital gains yield still is 4
percent, so the long-term dividend yield is 10 percent. In this situation, the stock price would be
about $25.
10-41 a. Part 1.
D̂ 1 = D0(1 + gs) = $1.60(1.20) = $1.92
D̂ 2 = D0(1 + gs)2 = $1.60(1.20)2 = $2.304
D̂3 $2.304(1.06) $2.44224

P̂2 = = = = 61.06
rs - gn orm 0.10 - 0.06 0.04
D̂1 D̂2 + P̂2

P̂0 = PV (D̂1 ) + PV(D̂ 2 ) + PV(P̂2 ) = +
(1 + rs ) (1 + rs )2
1
= $1.92(0.90909 ) + $2.304(0.82645 ) + $61.06(0.82645 ) = $54.11
Calculator solution: Input 0, 1.92, 63.364 = (2.304 + 61.06) into the cash flow register, and
input I/Y = 10 compute PV = $54.11.
Part 2.
Expected dividend yield: D̂ 1 /P0 = $1.92/$54.11 = 3.55%
Capital gains yield: First, find P̂1 which equals the sum of the present values of D̂ 2 and P̂2 ,
discounted for one year.
D̂2 P̂2 $2.304 + $61.06

P̂1 = + = = $57.60
(1 + rs ) 1
(1 + rs ) 1
(1.10 )1
Calculator solution: Input FV = 63.364 = (2.304 + 61.06), N =1, and I/Y= 10; compute PV =
$57.60.
Second, find the capital gains yield:
10-17
Besley/Brigham
P̂1 - P0 $57.60 - $54.11

= = 0.0645 = 6.45%
P0 $54.11
Dividend yield = 3.55%

Capital gains yield = 6.45
10.00% = rs.
b. Due to the longer period of supernormal growth, the value of the stock will be higher for each
year. Although the total return will remain the same, r s = 10%, the distribution between dividend
yield and capital gains yield will differ: The dividend yield will start off lower and the capital
gains yield will start off higher for the five-year supernormal growth condition, relative to the
two-year supernormal growth state. The dividend yield will increase and the capital gains yield
will decline over the five-year period until dividend yield = 4% and capital gains yield = 6%. The
current value of the stock would be $45.85 in this situation.
c. Throughout the supernormal growth period, the total yield will be 10 percent, but the dividend
yield is relatively low during the early years of the supernormal growth period and the capital
gains yield is relatively high. As we near the end of the supernormal growth period, the capital
gains yield declines and the dividend yield rises. After the supernormal growth period has
ended, the capital gains yield will equal gnorm = 6%. The total yield must equal rs = 10%, so the
dividend yield must equal 10% - 6% = 4%.
d. Some investors need cash dividends (retired people) whereas others would prefer growth.
Also, investors must pay taxes each year on the dividends received during the year whereas
taxes on capital gains can be delayed until the gain is actually realized.
10-42 Integrative Problem
a. Some of the key features of a bond include the following:

(1) Par or face value. We generally assume a $1,000 par value, but par can be anything, and
often $5,000 or more is used.
(2) Coupon rate. The dollar coupon is the “rent” on the money borrowed, which is generally the
par value of the bond. The coupon rate is the annual interest payment divided by the par
value, and it is generally set at the value of r on the day the bond is issued. To illustrate,
the required rate of return on one of Tampa Electric’s bonds was 8 percent when they were
issued, so the coupon rate was set at 8 percent. If the company were to float a new issue
today, the coupon rate would be set at the going rate today (2008), which would be about 6
or 7 percent.
(3) Maturity. This is the number of years until the bond matures and the issuer must repay the
loan (return the par value).
(4) Call provision. Most bonds (except U.S. Treasury bonds) can be called and paid off ahead
of schedule after some specified “call protection period.” Generally, the call price is above
the par value by some “call premium.” We will see that companies tend to call bonds if
interest rates decline after the bonds were issued, so they can refund the bonds with lower
interest bonds. This is just like homeowners refinancing their mortgages if mortgage
interest rates decline.
(5) Issue date. The date the bond is originally issued.
10-18
Besley/Brigham
(6) Default risk is inherent in all bonds except Treasury bonds. The question here is: Will the
issuer have the cash to make the promised payments? Bonds are rated from AAA to D,
and the lower the rating, the riskier the bond, the higher its default risk premium, and,
consequently, the higher its required rate of return, rd.
(7) Special features, such as convertibility and zero coupons, will be discussed later.
b. The value of any asset is the present value of its expected future cash flows:
0 1 2 3 N-1 N
r% …
    
CF1 CF 2 CF 3 CF N−1 CF N

PV of CF = Value
c. The value of a bond is merely the present value of its expected future cash flows:
0 1 2 3 N-1 N
rd% …
INT INT INT INT INT
PV of INT
PV of M M
Bond Value
INT INT INT INT M

Vd = 1
+ 2
+ 3
+ ... + N
+
(1+ rd ) (1+ rd ) (1+ rd ) (1+ rd ) (1+ rd )N
If the cash flows have widely varying risk, or if the yield curve is not horizontal, which signifies
that interest rates are expected to change over the life of the cash flows, it would be logical for
each period’s cash flow to have a different discount rate. However, it is very difficult to make
such adjustments; hence it is common practice to use a single discount rate for all cash flows.
A bond has a specific cash flow pattern consisting of a stream of constant interest payments
plus the return of par at maturity. The annual coupon payment is the cash flow: pmt = (coupon
rate) x (par value) = 0.1($1,000) = $100. For a one-year bond, we have this cash flow time line
situation:
0 1
10%
PV = $ 90.91 $ 100
PV = 909.09 1,000
Value = $1,000.00
Expressed as an equation, we have:
10-19
Besley/Brigham
$100 $1,000
Vd = 1
+
(1.10) (1.10)1
= $90.91 + $909.09 = $1,000.
Numerical (regular calculator) solution: Given above.
Financial calculator solution: Input N = 1, I/Y = 10, PMT = 100, and FV = 1,000; compute PV =
-1,000
Spreadsheet solution: Use the PV financial function that is available on the spreadsheet.
For a 10-year, 10 percent annual coupon bond, the bond’s value is found as follows:
0 10% 1 2 3 9 10
…
100 100 100 100 100
PV of INT = $ 614.46
PV of M = 385.54 1,000
Value = $1,000.00
Numerical (regular calculator) solution:
1 − 1 N   1   1 − 1 10   1 
Vd = INT   + M
(1+rd )
 = $100   + $1,000 
(1.10 )

  + N   10
 (1.10 ) 

rd
  (1 r d )  
0 .10
 
= $100( 6.14457 ) + $1,000( 0.38554 ) = $614.46 + $358.54 = $1,000.00
Financial calculator solution: Input N = 10, I/Y = 10, PMT = 100, and FV = 1,000; compute PV =
-1,000
d. (1) Numerical (regular calculator) solution:
1 − 1 N   1   1 − 1 10   1 
Vd = INT   + M
(1+rd )
 = $100   + $1,000 
(1.13 )

  + N   10
 (1.13 ) 

rd
  (1 r d )  
0 .13

= $100( 5.42624 ) + $1,000( 0.29459 ) = $542.62 + $294.59 = $837.21
Financial calculator solution: Input N = 10, I/Y = 13, PMT = 100, and FV = 1,000; compute
PV = -837.21
10-20
Besley/Brigham
In a situation like this, where the required rate of return, r d, rises above the coupon rate, the
bonds’ values fall below par, so they sell at a discount.
(2) In the second situation, where rd falls to 7 percent, the price of the bond rises above par.
Just change rd from 13 percent to 7 percent. We see that the value of the 1-year bond rises
to $1,028.04, and the 10-year bond goes to $1,210.71.
Numerical (regular calculator) solution:
1 − 1 N   1   1 − 1 10   1 
Vd = INT   + M
(1+rd )
 = $100   + $1,000 
(1.07 )

   
 (1 + rd ) 
N 10

rd
 
0 .07
  (1.07 ) 
= $100( 7.02358 ) + $1,000( 0.50835 ) = $702.36 + $508.35 = $1,210.71
Financial calculator solution: Input N = 10, I/Y = 7, PMT = 100, and FV = 1,000; compute
PV = -1,210.71
Thus, when the required rate of return falls below the coupon rate, the bonds’ value rises
above par, or to a premium. Further, the longer the term to maturity, the greater the price
effect of any given interest rate change.
(3) Assuming that interest rates remain at the new levels (either 7 percent or 13 percent), we
could find the bond’s value as time passes, and as the maturity date approaches. If we
then plotted the data, we would find the situation shown in the following graph:
Bond Value, Vd
($)
Time Path of Bond Value When rd (10%) = Coupon Rate (10%) M = $1,000
Market Price = Par Value: Par Bond
Time Path of Bond Value When rd (13%) > Coupon Rate (10%)
Market Price > Par Value: Discount Bond
At maturity, the value of any bond must equal its par value (plus accrued interest). As a
result, if interest rates, hence the required rate of return, remain constant over time,
then a bond’s value must move toward its par value as the maturity date approaches.
Thus, the value of a premium bond decreases to $1,000, and the value of a discount
bond increases to $1,000 (barring default).
e. (1) The yield to maturity (YTM) is the discount rate that equates the present value of a
bond’s cash flows to its price—that is, it is the promised rate of return on the bond.
10-21
Besley/Brigham
(Note that the expected rate of return is less than the YTM if some probability of default
exists.) On a cash flow time line, we have the following situation when the bond sells for
$887:
0 1 2 3 9 10
10% …
90 90 90 90 90
PV of INT
PV of M 1,000
$887 = Value
We want to find rd in this equation:
INT INT M
Vd = PV = 1
+ ... + N
+ N
.
(1+ rd ) (1+ rd ) (1+ rd )
We can estimate the YTM using the following computation:
 M - Vd 
INT +  
Approximat e  N 
=
Yield to Maturity  (2  Vd ) + M 
 3 
 
$90 +  $1,000 - $887 

 10 
= = 0.1096 = 10.96%
 2($887) + $1,000 
 
 3 
Thus, the YTM is approximately 10.96%.
Numerical (regular calculator) solution: Use a trial-and-error process—that is, plug in

values for rd until the PV of the cash flows is $887.
Financial calculator solution: Input N = 10, PV = -887, PMT = 90, and FV = 1,000; compute
I/Y = 10.91
Spreadsheet solution: use the rate financial function that is available on the spreadsheet.
We can tell from the bond's price, even before we begin the calculations, that the YTM
must be above the 9 percent coupon rate. We know this because the bond is selling at a
discount, and discount bonds always have rd > coupon rate.
If the bond were priced at $1,134.20, then it would be selling at a premium. In this case, the
bond must have a YTM that is below the 9 percent coupon rate, because all premium
bonds must have coupons that exceed the going interest rate. Going through the same
procedures as before, we find that at a price of $1,134.20, rd = YTM = 7.08%.
(2) The current yield is defined as follows:
Current Annual interest payment

=
Yield Current price of the bond
The capital gains yield is defined as follows:

10-22
Besley/Brigham
 Pr ice at the   Pr ice at the 

 − 
Capital Gains  end of the year   beginning of the year 
=
Yield Price at the beginning of the year
The total expected return is the sum of the current yield and the expected capital gains
yield:
Expected  Expected   Expected capital 

= + 
total return  current yield   gains yield 
The term yield to maturity, or YTM, is often used in discussing bonds. It is simply the
expected total return (assuming no default risk), so r̂ = expected total return = expected
YTM.
Recall also that securities have required returns, r, which depend on a number of factors:
Required return = r = r* + IP + LP + MRP + DRP
We know that (1) security markets are normally in equilibrium, and (2) that for equilibrium
to exist, the expected return, r̂ = YTM, as seen by the marginal investor, must be equal to
the required return, r. If this equality does not hold, then buying and selling will occur until it
does hold, and equilibrium is established. Therefore, for the marginal investor:
r̂ = YTM = r
For our 9 percent coupon, 10-year bond selling at a price of $887 with a YTM of 10.91
percent, the current yield is:
$90
C urrent Y ield = = 0.1015 = 10.15%
$887
Knowing the current yield and the total return, we can find the capital gains yield:
YTM = Current yield + Capital gains yield
Capital gains yield = YTM - Current yield = 10.91% - 10.15% = 0.76%
The capital gains yield calculation can be checked by asking this question: “What is the
expected value of the bond one year from now, assuming that interest rates remain at
current levels?” This is the same as asking: “What is the value of a 9-year, 9 percent
annual coupon bond if its YTM (its required rate of return) is 10.91 percent?” The answer,
using a financial calculator, is $893.87. With this data, we can now calculate the bond’s
capital gains yield as follows:
Capital gains yield = (Vd1 - Vd0)/Vd0

= ($893.87 - $887)/$887 = 0.0077 = 0.77%,
which agrees with our earlier calculation (except for rounding).
When the bond is selling for $1,134.20 and providing a total return of r = YTM = 7.08%, we
have this situation:
10-23
Besley/Brigham
Current yield = $90/$1,134.20 = 7.94%

and
Capital gains yield = 7.08% - 7.94% = -0.86%.
The bond provides a current yield that exceeds the total return, but a purchaser
would incur a small capital loss each year, and this loss would exactly offset the excess
current yield and force the total return to equal the required rate. The value of the bond
one year later would be $1,124.67.
f. Vd = $887.00
Financial calculator solution: Input N = 5, PV = -887, PMT = 90, and FV = 1,090; compute
I/Y = 13.63%
Vd = $1,134.20
Financial calculator solution: Input N = 5, PV = -1,134.20, PMT = 90, and FV = 1,090;

compute I/Y = 7.26%
g. Interest rate price risk, which is often just called price risk, is the risk that a bond will lose value
as the result of an increase in interest rates. Earlier, we developed the following values for a 10
percent, annual coupon bond:
Maturity
r 1-year Change 10-year Change
7% $1,028 $1,211
10 1,000 2.7% 1,000 17.4%
13 973 2.7% 837 16.3%
A 3 percentage point increase in r causes the value of the one-year bond to decline by only 2.7
percent, but the 10-year bond declines in value by more than 16 percent. Thus, the 10-year
bond has more interest rate price risk. The graph below shows the relationship between bond
values and interest rates for a 10 percent, annual coupon bond with different maturities. The
longer the maturity, the greater the change in value for a given change in interest rates, r d.
10-24
Besley/Brigham
h. Interest rate reinvestment rate risk is defined as the risk that cash flows (interest plus principal
repayments) will have to be reinvested in the future at rates different than today’s rate. To
illustrate, suppose you just won the lottery and now have $500,000. You plan to invest the
money and then to live on the income from your investments. Suppose you buy a one-year
bond with a YTM of 10 percent. Your income will be $50,000 during the first year. Then, after
one year, you will receive your $500,000 when the bond matures, and you will then have to
reinvest this amount. If rates have fallen to 3 percent, then your income will fall from $50,000 to
$15,000. On the other hand, had you bought 30-year bonds that yielded 10 percent, your
income would have remained constant at $50,000 per year. Clearly, buying bonds that have
short maturities carries reinvestment rate risk. Note that long maturity bonds also have
reinvestment rate risk, but the risk applies only to the coupon payments, and not to the principal
amount. Because the coupon payments are significantly less than the principal amount, the
reinvestment rate risk on a long-term bond is significantly less than on a short-term bond.
i. In reality, virtually all bonds issued in the U.S. have semiannual coupons and are valued using
the setup shown below:
Periods 0 1 2 3 n-1 n
r%/2 …
PMT/2 PMT/2 PMT/2 PMT/2 PMT/2
PV of INT
PV of M M
VALUE
We would use this equation to find the bond's value:
2N INT/ 2 M
VB =  (1+ r
t =1 d / 2)t
+
(1+ rd / 2 )2 N
.
The payment stream consists of an annuity of 2N payments plus a lump sum equal to the
maturity value.
10-25
Besley/Brigham
For a 10 percent, semiannual payment, 1-year bond, semiannual interest = annual coupon/2 =
$100/2 = $50 and N = 2(years to maturity) = 2(1) = 2. To find the value of the bond with a
financial calculator, enter N = 2, rd/2 = I/Y = 5, PMT = 50, FV = 1000, and then compute PV = -
$1,000.
To find the value of the 10-year, semiannual payment bond, enter N = 20 to override the N = 2,
and compute PV = -$1,000.
You could then change r = I/Y to see what happens to the bond’s value as r changes, and plot
the values—the graph would look like the one we developed earlier.
For example, if r rose to 13 percent, we would input I/Y = 6.5 rather than 5 percent, and find the
10-year bond’s value to be $834.72. If r fell to 7 percent, then input I/Y = 3.5 and compute PV =
-$1,213.19.
We could find the values with a financial calculator as described here, or we could use the
previous equation or a spreadsheet as described earlier.
i. The semiannual payment bond would be better. Its ear would be:
m 2
 r SIMPLE   0.10 
rEAR = 1+  − 1= 1+  − 1 = 0.1025 = 10.25%.
 m   2 
   
A rEAR of 10.25 percent is clearly better than one of 10.0 percent, which is what the annual
payment bond offers. You, and everyone else, would prefer it.
If the going rate of interest on semiannual bonds is rSIMPLE = 10%, with a rEAR of 10.25 percent,
then it would not be appropriate to find the value of the annual payment bond using a 10
percent rEAR. If the annual payment bond were traded in the market, its value would be found
using 10.25 percent, because investors would insist on getting the same rEAR on the two bonds,
because their risk is the same. Therefore, you could find the value of the annual payment bond,
using 10.25 percent, with your calculator. It would be $984.80 versus $1,000 for the semiannual
payment bond.
Note that, if the annual payment bond were selling for $984.80 in the market, its r EAR would be
10.25 percent. This value can be found by entering N = 10, PV = -984.80, PMT = 100, and FV
= 1000 into a financial calculator and then computing r = I/Y = 10.25%. With this rate, and the
$984.80 price, the annual and semiannual payment bonds would be in equilibrium—that is,
investors would get the same rate of return on either bond, so there would not be a tendency to
sell one and buy the other (as there would be if they were both priced at $1,000.)
k. The value of a perpetuity is simply:
PMT
Vd =
r
10-26
Besley/Brigham
Thus:
$100
V10% = = $1,000.00
0.10
$100
V13% = = $769.23
0.13
$100
V 7% = = $1,428.57
0.07
Perpetual bonds actually have the most interest rate risk of any coupon bond—their value
changes the most as interest rates change. (However, a zero coupon bond can be more
volatile than even a perpetuity. The controlling factor is duration, which we do not discuss in
this book.)
10-43 Integrative Problem
a. Preferred stock generally pays a constant dividend, whereas common stock often pays variable
dividends. Neither preferred stock nor common stock has a maturity. Whether preferred or
common, stockholders cannot force bankruptcy when dividends are not paid. Preferred
stockholders generally do not have voting rights, whereas common stockholders have the
ability to elect the firm’s board of directors. Any distribution of earnings—that is, dividends—or
proceeds from the liquidation of the company are paid to preferred stockholders before
common stockholders are paid. Because preferred dividends are constant, the common
stockholders receive the benefit of earnings that are greater than normal, and vice versa.
b. (1) The value of any stock is the present value of its expected dividend stream:
D̂1 D̂2 D̂3 D̂

P̂0 = 1
+ 2
+ 3
+ ... + 
.
(1+ rs ) (1+ rs ) (1+ rs ) (1+ rs )
However, some stocks have dividend growth patterns that allow them to be valued
using short-cut formulas.
(2) A constant growth stock is one whose dividends are expected to grow at a constant rate
forever. “Constant growth” means that the best estimate of the future growth rate is
some constant number, not that we really expect growth to be the same each and every
year. Many companies have dividends that are expected to grow steadily into the
foreseeable future, and such companies are valued as constant growth stocks.
For a constant growth stock:
D̂ 1 = D0(1 + g), D̂ 2 = D̂ 1 (1 + g) = D0(1 + g)2, and so forth.
With this regular dividend pattern, the general stock valuation model can be
simplified to the following very important equation:
10-27
Besley/Brigham
D̂1 D0(1+ g)
P̂0 = = .
rs - g rs - g
This is the well-known “Gordon,” or “constant-growth” model for valuing stocks. Here D̂ 1 , is
the next expected dividend, which is assumed to be paid one year from now, r s is the
required rate of return on the stock, and g is the constant growth rate.
(3) The model is derived mathematically, and the derivation requires that r s > g. If g is greater
than rs, the model gives a negative stock price, which is nonsensical. The model simply
cannot be used unless (a) rs > g, (b) g is expected to be constant, and (c) g can reasonably
be expected to continue indefinitely.
c. Here D = $10 and rs = 8%. Thus, P0 = $10/0.08 = $12.50.
d. (1) Because Bon Temps is a constant growth stock, its dividend is expected to grow at a
constant rate of 6 percent per year. Expressed as a cash flow time line, we have the
following setup. Just enter $2 in your calculator; then keep multiplying by 1 + g = 1.06 to
get D̂ 1 , D̂ 2 , and D̂ 3 :
0 1 2 3
16%
D̂ 1 = 2(1.06) = 2.1200 D̂ 2 = 2(1.06)2 = 2.2472 D̂ 3 = 2(1.06)3 = 2.3820

1.8276
1.6700
1.5260
5.0236 = PV
(2) We could extend the cash flow time line on out forever, find the value of Bon Temps’
dividends for every year on out into the future, and then the PV of each dividend,
discounted at rs = 16%. For example, the PV of D̂ 1 is $1.8276, the PV of D̂ 2 is $1.6700, and
so forth. Note that the dividend payments increase with time, but as long as r s > g, the
present values decrease with time. And, because the stock is growing at a constant rate,
its value can be estimated using the constant growth model:
D̂1 $2.12 $2.12

P̂0 = = = = $21.20.
r s - g 0.16 - 0.06 0.10
(3) After one year, D̂ 1 will have been paid, so the expected dividend stream will then be
D̂ 2 , D̂ 3 , D̂ 4 , and so forth. Thus, the expected value one year from now is $22.47:
D̂ 2 $2.2472
P̂1 = = = $22.47
r s −g 0.16 − 0.06
(4) The expected dividend yield in any year n is
Dividend D̂ n
=
Yield P̂n−1
10-28
Besley/Brigham
and the expected capital gains yield is
Capital Gains P̂n − P̂n−1 D̂ n

= = rs −
Yield P̂n−1 P̂n−1
Thus, the dividend yield in the first year is 10 percent and the capital gains yield is 6
percent:
Total return = 16.0%

Dividend yield = 10.0% = $2.12/$21.20 = 0.10
Capital gains yield = 6.0% = ($22.47 - $21.20)/$21.20
e. The constant growth model can be rearranged to this form:
D̂1
r̂s = + g.
P0
Here the current price of the stock is known, and we solve for the expected return. For Bon
Temps:
r̂s = $2.12/$21.20 + 0.060 = 0.100 + 0.060 = 16%.
f. If Bon Temps’ dividends were not expected to grow at all, then its dividend stream would be a
perpetuity. Perpetuities are valued as shown below:
0 1 2 ∞-1 ∞
16%
…
2 2 2 2
$12.50
Note that preferred stock is generally a perpetuity, so it can be valued with this formula.
PMT $2
PVP = = = $12.50
rs 0.16
g. Bon Temps no longer is a constant growth stock, so the constant growth model is not
applicable. Note, however, that the stock is expected to become a constant growth stock in
three years. Thus, it has a nonconstant growth period followed by constant growth. The easiest
way to value such nonconstant growth stocks is to set the situation up on a cash flow time line
as shown below:
10-29
Besley/Brigham
0 1 2 3 4 ∞
16%
…
g1=30% g1=30% g3=30% gn=6%
2.2414 2.600 3.380 4.394 4.658
2.5119
2.8150 4.658
29.8418 46.58 = = P̂3
0.16 − 0.06
37.4101
Simply enter $2 and multiply by (1.30) to get D̂ 1 = $2.60; multiply that result by 1.3 to get D̂ 2 =
$3.38, and so forth. Then, recognize that after Year 3, Bon Temps becomes a constant growth
stock, and at that point P̂3 can be found using the constant growth model. P̂3 is the present
value as of t = 3 of the dividends in Year 4 and beyond.
With the cash flows for D̂1, D̂ 2 , D̂ 3 , and P̂3 shown on the time line, we discount each value back
to Year 0, and the sum of these four PVs is the value of the stock today, P 0 = $37.410.
The dividend yield in Year 1 is 6.95 percent, and the capital gains yield is 9.05 percent:
$2.600
D ividend Y ield = = 0.0695 = 6.95%
$37.410
Capital G ains Y ield = 16.00% - 6.95% = 9.05%
During the nonconstant growth period, the dividend yields and capital gains yields are not
constant, and the capital gains yield does not equal g. However, after Year 3, the stock
becomes a constant growth stock, with g = capital gains yield = 6.0% and dividend yield =
16.0% - 6.0% = 10.0%.
h. Now we have this situation:
0 1 2 3 4 ∞
gn=6%
1.7241 2.00 2.00 2.00 2.12
1.4863
1.2813 2.12
13.5819 21.20 = = P̂3
0.16 − 0.06
18.0736
During Year 1:
$2.00
D ividend Y ield = = 0.1107 = 11.07%
$18.07
C apital G ains Y ield = 16.00% − 11.07% = 4.93%
Again, in Year 4 Bon Temps becomes a constant growth stock; hence g = capital gains
yield = 6.0% and dividend yield = 10.0%.
10-30
Besley/Brigham
i. The company is earning something and paying some dividends, so it clearly has a value
greater than zero. That value can be found with the constant growth formula, but where g is
negative:
D1 D0 (1+ g) $2.00(0.94) $1.88

P0 = = = = = $8.55.
rs - g rs - g 0.16 - (-0.06) 0.22
Because it is a constant growth stock:
g = Capital gains yield = -6.0%,

Hence:
Dividend yield = 16.0% - (-6.0%) = 22.0%.
As a check:
$1.88
D ividend Y ield = = 0.220 = 22.0%.
$8.55
The dividend and capital gains yields are constant over time, but a high (22.0 percent) dividend
yield is needed to offset the negative capital gains yield.
10-44 Computer-Related Problem
a. INPUT DATA: KEY OUTPUTS:
Supernormal growth 12.00% Current price (P0) $31.50

Normal growth rate 4.00% Price at the end of Year 5 $40.09
Req. rate of return 12.00% Dividend yield in Year 1 6.22%
Last dividend (D0) $1.75 Dividend yield in Year 5 8.00%
Supernormal period 5 years Cap. gains yield in Year 1 5.78%
Cap. gains yield in Year 5 4.00%
Total return both yrs 12.00%
MODEL-GENERATED DATA:
Expected dividends: PV of dividends:
Year 1 1.9600 Year 1 1.7500

Year 2 2.1952 Year 2 1.7500
Year 3 2.4586 Year 3 1.7500
Year 4 2.7537 Year 4 1.7500
Year 5 3.0841 Year 5 1.7500
Stock price—end of Year 1 40.09 Stock price—beginning of Year 1 31.50
Yields in Year 1 Yields in Year 1
Dividend 8.00% Dividend 6.22%

Capital Gain 4.00% Capital Gain 5.78%
Total 12.00% Total 12.00%
b. (1) r = 13%
10-31
Besley/Brigham
INPUT DATA: KEY OUTPUTS:

Year 1 1.9600 Year 1 1.7453

Year 2 2.1952 Year 2 1.7192
Year 3 2.4586 Year 3 1.7039
Year 4 2.7537 Year 4 1.6889
Year 5 3.0841 Year 5 1.6739

b. (2) r = 15%

Year 1 1.9600 Year 1 1.7043

Year 2 2.1952 Year 2 1.6599
Year 3 2.4586 Year 3 1.6166
Year 4 2.7537 Year 4 1.5744
Year 5 3.0841 Year 5 1.5333
10-32
Besley/Brigham

b. (3) r = 20%

Year 1 1.9600 Year 1 1.6333

Year 2 2.1952 Year 2 1.5244
Year 3 2.4586 Year 3 1.4228
Year 4 2.7537 Year 4 1.3280
Year 5 3.0841 Year 5 1.2394

ETHICAL DILEMMA
Which Arm Should You Choose—The Left or The Right?
Ethical dilemma:
As a loan officer for FIFO, Alan’s job is to sell loans that generate revenues for the company. Alan has
been charged with increasing the amount of mortgages that are sold by FIFO. One of the loans that
FIFO wants to emphasize is a new mortgage called an option ARM. The primary benefit to the borrower
is that the monthly amount that is paid in the early years of the mortgage can be set so that he or she
can afford to purchase a house. However, this benefit leads to the primary disadvantage associated
with an option ARM. The difference between the principal and interest that would be paid on an
10-33
Besley/Brigham
equivalent conventional mortgage and the amount paid on the option ARM is added to the amount owed
by the borrower. As a result, the borrower generally owes more than the original principal amount when
the option ARM converts to a conventional mortgage. When the option ARM becomes a conventional
mortgage in three to five years, the monthly payments can increase more than five fold, which becomes
a significant burden to the borrower. If the borrower cannot afford the new, substantially higher
payments, then he or she will default on the mortgage and lose the house.
Discussion questions:
• Is there an ethical problem? If so, what is it?
In this case, the ethical situation would be the manner in which FIFO conducts its lending business.
Apparently FIFO has an unwritten policy that the loan officers should provide only information that is
required by law. Thus, loan officers are encouraged to withhold “bad” information that doesn’t have to
be disclosed, unless customers specifically request such information. Alan is concerned that if he
follows company policy he might be providing mortgages that will result in the financial ruin of his
customers in three to five years. On the one hand, the company wants to “book” as many option ARMs
as it can, because revenues that won’t be paid until later years can be recognized in the early years of
the mortgage. On the other hand, those who borrow using option ARMs might find that they cannot
afford the significantly higher mortgage payments that “kick in” after the low-payment period expires.
Are option ARMs appropriate for borrowers? Clearly, option ARMs serve a particular niche—borrowers
who cannot afford the payments associated with a conventional mortgage today, but will have the
ability/means to pay higher-than-conventional mortgage payments when the low-payment option period
expires. Because option ARMs are complex lending agreements, the primary question is: How much
information should be provided to prospective borrowers? When describing option ARMs, should FIFO’s
loan officers inform their clients as to the pitfalls associated with this borrowing alternative?
• Is FIFO’s policy about disclosing information to borrowers appropriate?
The dilemma is what information FIFO’s loan officers should provide to prospective borrowers. What
obligation, does FIFO have to provide information and advice to its customers beyond what is required
by law? Such questions apply to all businesses, not just lenders. Should businesses fully disclose
information about their products, even if the information might be harmful to sales?
If you believe that FIFO’s loan officers should provide quality advice at the same time they try to “sell”
mortgages, then perhaps such advice will convince many customers not to borrow using option ARMs,
which might also mean that many of these customers probably would not be able to borrow at all. As a
result, full disclosure of information most certainly would decrease the revenues that FIFO would
generate otherwise.
• What would you do if you were Alan?
In any business, especially a service-oriented business, reputation is very important. If FIFO does not
treat its customers appropriately, the word will spread around the industry and the company will lose
future business. Also, if he follows the company’s unwritten policy of not fully disclosing information that
might jeopardize a deal unless the law states that such information must be disclosed, there is a good
chance that Alan will be burdened with a bad reputation in the lending arena, which will decrease his
chances of getting a good job with another company in the future.
Most times, unethical behavior is rewarded with severe penalties. As a result, it would behoove Alan to
act ethically by fully informing potential borrowers as to both the benefits and the detriments of the loans
he is trying to sell, and by helping clients to reach decisions that are in their best interests.
10-34
Chapter 10
References:
The following articles might be assigned for background material:
James R. Hagerty, “Mortgage Brokers: Friends or Foes?” The Wall Street Journal Online, May 24, 2007.
(http://online.wsj.com/)
Riva Richmond, “ValueClick Ad Practices Draw Regulatory Scrutiny,” The Wall Street Journal Online,
May 23, 2007. (http://online.wsj.com/)
Ruth Simon, “Debating Standards for Mortgage Lenders,” The Wall Street Journal Online, March 8,
2007, D1. (http://online.wsj.com/)
Mara Der Hovanesian, “Mortgages—They Promise the American Dream: A Home of Your Own—With
Ultra-Low Rates and Payments Anyone Can Afford. Now the Trap Has Sprung,” BusinessWeek, pp. 71-
81.
10-35

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10-10 Effect on Value

b. The company increases dividends. +

c. The company’s growth rate increases. +

d. Investors become more risk averse. –

10-7 Dividend = 0.10($80) = $8

10-8 D̂1 = $5(1.04 ) = $5.20

D̂1 D0 (1+ g) $5.20

10-9 D̂1 = $1.50(1.02) = $1.53

D̂1 D0 (1+ g) $1.53

Solving for g, we find the growth rate to be 5 percent:

$4.32 – $36g = $2.40 + $2.40g

P̂5 = P0 (1 + g)n = $36(1.05)5 = $36(1.27628) = $45.95

D̂1 D0 (1+ g) $5[1+ (-0.05)] $4.75

D̂1 = P̂0 (rs − g)= $28( 0.07 ) = $1.96

(1) 5%: Bond L: Vd = $100(10.37966) + $1,000(0.48102) = $1,518.99

(2) 7%: Bond L: Vd = $100(9.107914) + $1,000(0.362446) = $1,273.24

(3) 11%: Bond L: Vd = $100(7.19087) + $1,000(0.209004) = $928.09

10-14 a. Year Dividend

D̂1 D0 (1+ g) $2(1.05) $2.10

The current price is the present value of D̂ 1 , D̂ 2 , and P̂2 :

$1.50 $1.875 + $28.393

= $1.50( 0.88496 ) + $30.268( 0.78315 )

$0 $0 $1.00 $1.50 $2.25 + $34.7143

= $1.00( 0.65752 ) + $1.50( 0.57175 ) + $36.9643( 0.49718 )

$2.50 $3.00 $4.00

= $2.50(0.87719) + $3.00(0.76947) + $4.00(0.67497) = $7.20

$4(1+ 0.04) $4.16

PV of D̂ = $1.3225(0.89286) + $1.5209(0.79719) + $1.7186(0.71178)

(2) Find the PV of Snyder’s stock price at the end of Year 3:

PV of P̂3 = $30.36(0.71178) = $21.61

P̂0 = $3.62 + $21.61 = $25.23.

Alternatively, the cash flows can be placed on a time line as follows:

b. P̂1 = $1.5209(0.89286) + $1.7186(0.79719) + $30.36(0.79719)

P̂2 = $1.7186(0.89286) + $30.36(0.89286)

c. Dividend Capital Gains Total

YTM = 6.0% x 2 = 12.0%

10-20 Calculator solution: N = 5, PV = -567.44, PMT = 0, and FV = 1,000; I/Y = 12.0%

YTM = 3.823% x 2 = 7.646%

10-23 a. M = $1,000 = FV on the calculator

Calculator solution: YTM = 14.99%

Calculator solution: YTM = 6.00%

= 90(3.03735) + 1,000(0.63552) = 908.88

(1) Return = [($925 - $1,000) + $80]/$1,000 = 0.005 = 0.5%

(2) Current yield = $80/$1,000 = 0.08 = 8.0%

Capital gains = (-$75)/$1,000 = -0.075 = -7.5%

Total return = Current yield + Capital gains = 8.0% - 7.5% = 0.5%

10-25 Vd = INT/rd; therefore, rd = INT/Vd.

INT = 0.08($1,000) = $80

(a) rd = $80/$600 = 13.3%

(b) rd = $80/$800 = 10.0%

(c) rd = $80/$1,000 = 8.0%

(d) rd = $80/$1,500 = 5.3%

Preferred: $2/quarter forever, $95/share

Bonds: Selling at a discount, so rd > Coupon.

rEAR = (1.04563)2 – 1 = 9.33%, YTM = 9.33%.

Preferred: $2/$95 = periodic (quarterly) rate of 2.11%.

rEAR = (1.0211)4 – 1 = 8.69%.

Thus, the bond has a higher EAR.

Rate of $21 - $15 $0.90 $6.90 Capital Dividend

Rate of $27.50 - $25.00 $1.25 $3.75 Capital Dividend

10-32 a. g = $1.1449/$1.07 - 1.0 = 7%.

Calculator solution: Input N = 1, PV = -1.07, and FV = 1.1449; compute I/Y= 7.00

or Input N = 2, PV = -1.07, and FV = 1.2250; compute I/Y= 7.00