Tutorial 3: Bonds and Equity

Bonds (continued)
1. A General Electric bond pays an annual coupon of 8%, has 9 years until maturity, and
is trading with a yield of 7%.
a. What payment do bondholders receive each year per €100 invested?
b. At what price must the bond be trading? (calculate using the bond price formula from
lectures)
c. If the bond were to trade at 120, what would be the yield of the bond? (solve using excel)

2. A bond’s credit rating provides a guide to its risk. Long-term bonds rated Aa currently
offer yields to maturity of 7.5%. A-rated bonds sell at yields of 8%. A 10-year bond
with a coupon rate of 7% is trading at 96.55, which represents a yield of 7.5%. If it is
downgraded by Moody’s from Aa to A rating, will its price rise or fall? What will the
price be before and after?

3. General Matter’s outstanding bond issue has a coupon rate of 10%, and it sells at a
yield to maturity of 9.25%. The firm wishes to issue additional bonds to the public
with a par value of 100. What coupon rate must the new bonds offer in order to sell at
their par value?

Equities
1. Amazon.com had not yet paid a dividend, but the market value of its stock is $1.6 trillion.
Does this invalidate the dividend discount model?

2. Preferred Products has issued preferred stock with an $8 annual dividend that will be paid
in perpetuity (preferred stock pays a fixed dividend with no growth). If the discount rate
is 12%, at what price should the preferred stock sell?

3. Waterworks has a dividend yield of 8%. If its dividend is expected to grow at a constant
rate of 5%, what must be the expected rate of return on the company’s stock?
4. How can we say that price equals the present value of all future dividends when many
actual investors may be seeking capital gains and planning to hold their shares for only a
year or two? Explain.

5. A company will pay a $2 per share dividend in 1 year. The dividend in 2 years will be $4
per share, and it is expected that dividends will grow at 5% per year thereafter. The
expected rate of return on the stock is 12%. What is the current price of the stock?

6. Better Mousetraps has come out with an improved product, and the world is beating a
path to its door. As a result, the firm projects growth of 20% per year for 4 years. By then,
other firms will have copycat technology, competition will drive down profit margins,
and the sustainable growth rate will fall to 5%. The most recent annual dividend was
DIV0 = 1 per share.
a. What are the expected values of DIV1, DIV2, DIV3, and DIV4?
b. What is the expected stock price 4 years from now? The discount rate is 10%.
c. What is the stock price today?