VALUATION OF BONDS AND STOCKS

EXERCISES

A. Multiple Choice: Concepts

1. It is the annual rate of interest earned on a security purchased on a
given date and held until the maturity date.
a. term structure
b. yield curve
c. risk-free rate
d. yield to maturity

2. An increase in risk will result in a required rate of return or interest rate

which is ____________.
a. lower
b. higher
c. unchanged
d. undetermined

3. The required rate of return on a 3-month treasury bill is considered

a. nominal
b. real
c. risk-free
d. premium

4. It is risk with regard to the change in the purchasing power of the

currency.
a. default risk
b. inflationary risk
c. tax treatment risk
d. liquidity risk

5. If a bond pays Php100,000 and interest at the date of maturity, the

Php100,000 is best described as the
a. stated value
b. market value
c. par value
d. long-term value

6. The value of a bond is computed as the present value of the

a. dividends and maturity value
b. interest and dividend payments
c. maturity value
d. interest payments and maturity value.

7. The price of a bond with a fixed-coupon rate and the market required
return have a relationship that is best described as
a. linear
b. inverse
c. constant
d. direct
8. When a firm buys a bond and the required return is constant but different
from the coupon rate, the price of a bond as it approaches the maturity
date will ____________.
a. remain constant
b. increase
c. decrease
d. approach the par.

9. In the present-value model, risk is generally incorporated into the

a. cash flows
b. timing
c. discount rate
d. total value.

10. When the required rate of return is different from the coupon rate, the
price of the bond as it approached its maturity date will
a. remain constant
b. increase
c. decrease
d. change depending on whether it is sold at a discount or premium.

11. A bond differs from a term in loans in that

a. a bond issue is generally advertised
b. a bond is sold to many investors
c. a bond is offered to the public
d. all of the above.

12. Which of the following bonds has the greatest percentage increase in
value if all interest rates in the economy fall by 1%?
a. 10-year, zero coupon bond
b. 20-year, 10%-coupon bond
c. 1-year, 10% coupon bond
d. 20-year, zero coupon bond.

13. A bond’s coupon rate

a. is equal to its annual coupon payment divided by the bond’s current
market price.
b. varies during the life of the bond
c. is equal to its annual coupon payment divided by its par value
d. both a and b

14. Zero-coupon bonds are an example of

a. original issue, deep-discount bonds
b. extendible notes
c. convertible bonds
d. floating-rate notes

15 The quality of a debenture depends on the

a. general credit-worthiness of the issuing company
b. value of the assets used as collateral
c. coupon rate of the debenture
d. length of time until maturity
16. It is a venue where equity capital is raised.
a. money market
b. Philippine bond market
c. retained earnings and the stock market
d. insurance company

17. In the Gordon’s growth mode, the value of the common stock is
computed as the
a. net value of all the assets which are liquidated for their exact accounting
value.
b. actual amount each common stockholder expects to receive if the firm’s
assets are sold; the creditors and preferred stockholders are repaid; and
any remaining money is divided among the common stockholders.
c. present value of a non-growing dividend stream
d. present value of a constant, growing dividend stream.

18. It is the value of the firm’s ownership in the event that all assets are
sold for their exact accounting value and the proceeds remaining after
paying all liabilities are divided among the common stockholders.
a. liquidation value
b. book value
c. P/E multiple
d. present value of the common stock

19. It is the actual amount each common stockholder expects to receive if

the firm’s assets are sold; creditors and preferred stockholders are repaid;
and any remaining money is divided among the common stockholders.
a. liquidation value
b. book value
c. P/E multiple
d. present value of the dividends

20. Which of the following valuation method of common stock takes

expected earnings into consideration?
a. liquidation value
b. book value
c. P/E multiple
d. present value of the interest

21. Which of the following statements is correct?

1. If a stock has a required rate of return r=12% and its dividend is
expected to grow at a constant rate of 5%, the stock’s dividend yield is
also 5%.

Answer: The price of a stock is the present value of all expected future
dividends, discounted at the dividend growth rate.
D
11. The stock valuation model , P= --------- , can be used to value firms
(r – g)
Whose dividends are expected to decline at a constant rate, i.e., grow at a
negative rate.
111. The price of a stock is the present value of all expected future
dividends , discounted at the dividend growth rate.
a. 1 is true’
b. 11 is true
c. 1 and 11 are true
d. 11 and 111 are true
e. all are true

22. Which of the following is not a barrier to a hostile takeover?

a. non-pecuniary benefits
b. targeted share repurchases
c. shareholder-rights provision
d. restricted voting rights
e. poison pill

23. Which of the following statements is not correct?

a. The corporate valuation model can be used even for a company
that does not pay dividends.
b. The corporate valuation model discounts free cash flows by the required
return on equity.
c. The corporate valuation model can be used to determine the value of a
division.
d. A important step in applying the corporate valuation model is forecasting
the pro-forma financial statements.
e. Free cash flows must grow at a constant rate in order to find the horizon
or terminal value.

24. Which of the following is not always a way of increasing the value of a
company?
a. increase the growth rate of sales
b. increase the operating profitability
c. decrease the capital requirement (capital/sales)
d. decrease the weighted average cost of capital
e. increase the expected return on invested capital.

25. In a reverse stock split

a. the number of shares decreases
b. the market value decreases
c. the retained earnings decrease
d. the par value decreases

26. The constant growth dividend valuation model does not hold when
a. k (required rate of return), is greater than g (growth rate)
b. dividends are growing faster than 4%
c. g is greater than k
d. the current dividend is known.
27. The returns investors receive from holding common stocks may be in
two forms, namely
a. cash dividend payments and capital gains
b. future earnings and treasury stock
c. stock splits and stock dividends
d. cash dividends and stock dividends

28. Which of the following statements is correct about equity capital?

a. it is temporary
b. it is a maturity date
c. it has priority over bonds
d. it is liquidated only in bankruptcy

29. When it comes to the claims over the assets of the corporation, the
common stockholders have priority over
a. preferred stockholders
b. secured creditors
c. unsecured creditors
d. none of the above’

30. Which of the following receives a promised fixed payment of dividends

before the common stockholders?
a. creditors
b. preferred stockholders
c. bondholders
d. none of the above.
STRAIGHT PROBLEMS

1. A stock is expected to pay a dividend of Php0.75 at the end of the year.

The required rate of return is r = 10%, and expected constant growth rate
is g=6%. What is the stock’s current price?

D1= 0.75
Rs= 10%
G= 6%
Po= D1/ (Rs-G)
Po= 0.75 / (10%-6%)
Po= 0.1875 or 18.75

2. ABC Corporation provided the following information:

Dividend (D) = Php1.25
Growth rate (g) = 5%
Price (P) = Php25.00
What is the stock’s expected dividend yield for the coming year?

3. If the firm’s D = Php2.00, g=5.0%, P=Php30.00, what is its stock’s

expected total return for the coming year?

4. A company forecasts a free cash flow of Php50 million in 5 years. It

expects the free cash flow to grow at a constant rate of 6% thereafter. If the
weighted average cost of capital is 12%, what is the horizon value.

5.Pau Corporation forecasts its free cash flow in 1 year to be negative

Php15 million and its free cash flow in 2 years to be Php25 million. After the
second year, its free cash flow will grow at a constant rate of 5% per year
forever. If the overall cost of capital is 15%, what is the current value of
operations to the nearest million?

6. Campau was founded 10 years ago. Although profitable for the last 5
years, it has all of its earnings to support growth and, thus, has never
declared a dividend. The management indicated that it plans to pay a
Php0.50 dividend in 3 years from today, then to increase it at a relatively
rapid rate for 2 years and finally to increase it at a constant rate of 8%
thereafter. The management’s forecast of the future dividend stream,
along with the forecasted growth rates, is shown below. Assuming a
required return of 12%, what is your estimate of the stock’s current value?
Year Growth rate Dividends
0 - Php 0
1 - 0
2 - 0
3 - 0.500
4 65.00% 0.825
5 32.50% 1.0931
6 8.00% 1.1810

7. Pau Company’s free cash flow during the just-ended year (t=0) was
Php100million, and its Free Cash Flow (FCF) is expected to grow at a
constant rate of 5% in the future. If the weighted average cost of capital
is 15%, what is the firm’s value of operations (in millions)?
8. Cam’s value of operations is Php850million. The company’s balance
sheet shows Php100million in short-term investments that are unrelated to
operations. The balance sheet also indicates Php100million in accounts
payable, Php150 million in notes payable, Php250 million in a long-term
debt, Php40million in common stock(par plus paid-in-capital), and
Php160million in retained earnings. What is your best estimate for the
market value of equity? Use the corporate-valuation model.

9. Using the Corporate-valuation model, the value of WRU operations is

Php800 million. Its balance sheet shows Php90million in notes payable,
Php100 million in long-term debt, Php50 million in preferred stock, Php140
million in retained earnings, and Php280 million in total common equity. If
the company has Php22.4 million shares of stocks outstanding, what is the
best estimate of its stock price per share?

10. To expand its business, Mari Outlay Factory plans to issue a bond with
a par value of Php1,000, coupon rate of 10% and maturity of 10 years
from now. What is the value of the bond if the required rate of return is:
a. 8%
b. 10%
c. 12%

11. Assume that you are considering the purchase of a 20-yeart, non-
callable bond with an annual coupon rate of 10%. The bond has a face
value of Php1,000, and it makes semi-annual interest payments. If you
require a 12%-nominal yield to maturity on this investment, what is the
maximum price you should be willing to pay for the bond?

12. A bond currently trades at Php975 in the secondary market. The bond
has 10 years of life left until maturity and pays an annual coupon of 9% of
its face value which is Php1,000. What is the yield to maturity?

13. Snackmo Inc. bonds currently sell for Php1,100. These bond pays a
Php90 annual coupon, have a 25-year maturity, and a Php1,000 par value,
but they can be called in 5 years at Php1,050. Assume that no costs other
than the call premium will be incurred to call and refund the bonds, and that
the yield curve is horizontal, with rates expected to remain at current
levels into the future. What is the difference between these bonds’ YTM
and YTC?

14. It is January 1, 2019 and you are considering whether or not to

purchase an outstanding bond that was issued on January 1, 2017. It has
a 9.5% annual coupon and a 30-year original maturity. (it matures on
December 31, 2045.) There is 5-year call protection (until December 31,
2019), after which date it can be held at 109- that is, at 109% of par, or
Php1,090. Interest rates have declined since the bond was issued, and it
is now selling at 116.575% of par, or Php1,165.75.
a. What is the yield to maturity? What is the yield to call?
b. If you buy this bond, which return will you actually earn? Explain.
c. Suppose the bond is selling at a discount rather than a premium. Will the
yield to maturity or the yield to call be more likely return?