Homework Chap 9 answers

1. Davis & Davis issued $1,000 par value bonds at 102. The bonds pay 12% interest annually and mature in 30 years. The
market rate of interest is (round to the nearest hundredth of a percent)
Answer: B 11.71%.
2. What is the expected rate of return on a bond that matures in seven years, has a par value of $1,000, a coupon rate of
14%, and is currently selling for $911? Assume annual coupon payments.
Answer: D 16.22%
3. Terminator Bug Company bonds have a 14% coupon rate. Interest is paid semiannually. The bonds have a par value
of $1,000 and will mature 10 years from now. Compute the value of Terminator bonds if investors' required rate of
return is 12%.
Answer: A $1,114.70
4. You paid $865.50 for a corporate bond that has a 6.75% coupon rate. What is the bond's current yield?
Answer: B 7.800%
5. Garvin, Inc.'s bonds have a par value of $1,000. The bonds pay semiannual interest of $40 and mature in five years.
a. How much would you pay for Garvin bonds if your required rate of return is 10%?
b. How much would you pay if your required rate of return is 8%?
Answer:
a. N=10, i=5, PMT=40, FV=1000, solve for PV=-922.78
Price = $922.78
b. Price = $1,000
6. If you are willing to pay $1,392.05 for a 15-year, $1,000 par value bond that pays 10% interest semiannually, what is
your expected rate of return?
Answer: N=30, PV=-1,392.05, PMT=50, FV=1000, solve for i=2.99 semi-annual rate, 2.99 % × 2 = 6%

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 Quiz Chap 9 – 30 Min
1. Advantages of privately placing debt include all of the following EXCEPT
A) speed.
B) reduced placement costs.
C) restrictive covenants (agreement).
D) flexibility.
2. The Blackburn Group has recently issued 20-year, unsecured bonds rated
BB by Moody's. These bonds yield 443 basis points above the U.S. Treasury
yield of 2.76%. The yield to maturity on these bonds is
A) 4.43%.
B) 7.19%.
C) 12.23%.
D) mortgage bonds.

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3. What is the value of a bond that has a par value of $1,000, a coupon rate of $80
(annually), and matures in 11 years? Assume a required rate of return of 11%, and
round your answer to the nearest $10.
A) $320.66
B) $1,011.00
C) $813.80
D) $790.79
4. Six years ago, Colt, Inc. sold an issue of 30-year, $1,000 par value bonds. The coupon
rate of 5.25% is payable annually. Investors presently require a rate of return of
8.375%. What is the current market price (intrinsic value) of the bonds? Round off to
the nearest $1.
A) $1,050
B) $932
C) $681
D) $1,111

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 Quiz Answers
1. Advantages of privately placing debt include all of the following EXCEPT
Answer: C restrictive covenants.
2. The Blackburn Group has recently issued 20-year, unsecured bonds rated BB by
Moody's. These bonds yield 443 basis points above the U.S. Treasury yield of 2.76%. The
yield to maturity on these bonds is
Answer: B 7.19%.
3. What is the value of a bond that has a par value of $1,000, a coupon rate of $80
(annually), and matures in 11 years? Assume a required rate of return of 11%, and round
your answer to the nearest $10.
Answer: C $813.80
4. Six years ago, Colt, Inc. sold an issue of 30-year, $1,000 par value bonds. The coupon rate
of 5.25% is payable annually. Investors presently require a rate of return of 8.375%. What is
the current market price (intrinsic value) of the bonds? Round off to the nearest $1.
Answer: C $681

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FINC6001- Financial Management

Financial Resources – Valuation of Stocks & Cost of Equity

Week 12
Chapter 8 (9th Ed. Chap 10)

Yanthi Hutagaol
Yanthi.Hutagaol@binus.ac.id

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 Session Learning Outcomes
Upon completion of this session, students are expected to be able to
• Identify the basic characteristics of preferred stock.
• Value preferred stock.
• Identify the basic characteristics of common stock.
• Value common stock.
• Calculate a stock’s expected rate of return.
• Explain the relationship of stocks’ expected returns and company’s
cost of equity

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Preferred stock

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 Preferred Stock
• Preferred stock is often referred to as a hybrid security because it has
many characteristics of both common stock and bonds.

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 Hybrid Nature of
Preferred Stocks
Like common stocks
• have no fixed maturity date
• failure to pay dividends does not lead to bankruptcy
• dividends are not a tax-deductible expense
Like Bonds
• dividends are fixed in amount (either as a $ amount or as a % of par value)

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 The Characteristics of
Preferred Stocks
• Multiple series of preferred stock
• Preferred stock’s claim on assets and income
• Cumulative dividends
• Protective provisions
• Convertibility
• Retirement provisions

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 Multiple Series
• If a company desires, it can issue more than one series of preferred
stock, and each series can have different characteristics (such as
different protective provisions and convertibility rights).

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 Claim on Assets and Income
Claim on Assets: Preferred stock has priority over
common stock with regard to claim on assets in the
case of bankruptcy.
• Preferred stockholders claims are honored before
common stockholders, but after bonds.
Claim on Income: Preferred stock also has priority
over common stock with regard to dividend
payments.
• Thus preferred stocks are safer than common stock but
riskier than bonds.

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 Cumulative Dividends
• Cumulative feature (if it exists) requires that all past, unpaid preferred
stock dividends be paid before any common stock dividends are
declared.

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 Protective Provisions
• Protective provisions generally allow for voting rights in the event of
nonpayment of dividends, or they restrict the payment of common
stock dividends if sinking-funds payments are not met or if the firm is
in financial difficulty.
• These protective provisions reduce the risk and consequently,
expected return.

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 Convertibility
• Convertible preferred stock can, at the discretion of the holder, be
converted into a predetermined number of shares of common stock.
• Almost one-third of preferred stock issued today is convertible
preferred.

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 Retirement Provisions
• Although preferred stock has no set maturity associated with it,
issuing firms generally provide for some method of retiring the stock
such as a call provision or sinking fund provision.
• Call provision entitles the corporation to repurchase its preferred
stock at stated prices over a given time period.
• Sinking fund provision requires the firm to set aside an amount of
money for the retirement of its preferred stock.

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Valuing preferred stock

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 Valuing Preferred Stock
• The economic or intrinsic value of a preferred stock is
equal to the present value of all future dividends.

• Preferred stock Value = Annual dividend

Required rate of return

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 Valuing Preferred Stock

Example: Assume PG&E preferred stock pays an

annual dividend of $1.25 and the investors required
rate of return is 5%.

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21
Common stock

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 Common Stock
• Common stock is a certificate that indicates ownership in a
corporation. When you buy a share, you buy a “part/share” of the
company and attain ownership rights in proportion to your “share” of
the company.
• Common stockholders are the true owners of the firm (Investors).
Bondholders and preferred stock holders can be viewed as creditors.

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 Claim on Income
• Common shareholders have the right to residual income after
bondholders and preferred stockholders have been paid.
• Residual income can be paid in the form of dividends or retained
within the firm and reinvested in the business.
• Claim on residual income implies:
1. there is no upper limit on income
2. shareholders are not guaranteed anything and may have to settle for zero
income in some years.

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 Claim on Assets
• Common stock has a residual claim on assets in the case of
liquidation, after claims of debt holders and preferred stockholders
have to be met prior to common stockholders
• Generally, if bankruptcy occurs, claims of the common shareholders
are typically not satisfied.

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 Limited Liability
• The liability of shareholders is limited to the amount of their
investment.
• The limited liability helps the firm in raising funds.

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 Voting Rights
• Most often, common stockholders are the only security holders with a
vote.
• Majority of shareholders generally vote by proxy.
• A proxy gives a designated party the temporary power of attorney to vote for
the signee at the corporation’s annual meeting.
• Proxy fights are battles between rival groups for proxy votes.
• Common shareholders are entitled to:
• elect the board of directors
• approve any change in the corporate charter

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 Voting Rights
• Voting for directors and charter changes occur at the corporation’s
annual meeting.
• With majority voting – each share of stock allows the shareholder one vote.
Each position on the board is voted on separately.
• With cumulative voting - each share of stock allows the stockholder a number
of votes equal to the number of directors being elected.

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 Voting for Board of Directors
• In the real world, shareholders do not really pick the board rather
they simply select from a list of nominees chosen by the
management.
• This opens the door for management favored boards, which may not
always be in the best interest of shareholders.

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 Preemptive Rights
• Preemptive right entitles the common shareholder to maintain a
proportionate share of ownership in the firm.
• Thus, if a shareholder currently owns 25% of the shares, s/he has the right to
purchase 25% of the shares when new shares are issued.
• These rights are issued in the form of certificates that give shareholders
the option to buy new shares at a specific price during a 2- to 10- week
period.
• These rights can be:
• Exercised
• Sold in the open market
• or allowed to expire.

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 Valuing
common stock

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 Valuing Common Stock
• Like bonds and preferred stock, the value of common stock is equal to
the present value of all future expected cash flows (i.e., dividends).

Annual dividend
• Common stock Value =
Required rate of return – growth rate

• However, dividends are neither fixed nor guaranteed, which makes it

harder to value common stocks compared to bonds and preferred
stocks.

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 Dividend Model
• Unlike preferred stock, common stock dividend is not fixed.

• Dividend pattern varies among firms, but dividends generally tend to

increase with the growth in corporate earnings.

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 How Can a Company Grow?
• Through Infusion of capital by borrowing or issuing new common
stock.
• Through Internal growth. Management retains some or all of the
firm’s profits for reinvestment in the firm, resulting in future earnings
growth and value of stock.
• Internal growth directly affects the existing stockholders and is the
only growth factor used for valuation purposes.

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 Internal Growth - g

g = ROE  pr
where:
g = the growth rate of future earnings and the growth in the
common stockholders’ investment in the firm

ROE = the return on equity

(net income/common book value)

pr = % of profits retained (profit retention rate)

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 Dividend Valuation Model
• Value of common stock = PV of future dividends

Vcs = Common stock value

D1 = dividend in year 1
rcs = required rate of return
g = growth rate

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 Example:
Dividend Valuation Model
• Consider the valuation of a common stock that paid $1.00 dividend at
the end of the last year and is expected to pay a cash dividend in the
future. Dividends are expected to grow at 5% and the investors
required rate of return is 10%.

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 Example:
Dividend Valuation Model
1. The dividend last year was $1. Compute the new dividend (D1 ) by:
g = 5% D0 = $1 rcs = 10%
D1 = D0(1 + g)
= $1(1 + .05) = $1.05

2. Vcs = D1/(rcs – g)
= $1.05/(.10 – .05)
= $21 - The value of the common stock
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 The expected rate of
return of Stockholders

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 Expected Rate of Return of Preferred
Stockholders
• The expected rate of return on a security is the required rate of return
of investors who are willing to pay the market price for the security.

• Example: If the current market price of preferred stock is $75, and the
stock pays $5 dividend,
• Expected rate of return = $5/$75 = 6.67%

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 Expected Rate of Return of Common Stockholders

rcs = Expected rate of return of common stocks

g = growth rate Pcs = market price

Example: The current market price of stock is $90 and the

stock pays dividend of $1.12 with a growth rate of 13.6%.

Expected rate of return = 14.8%

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 Expected Rate of Return of Common
Stockholders
• Historically, most of the returns on stocks has come from price
appreciation or capital gains.

• The S&P 500 Index has returned an average annual return of 10%
since 1926, with dividend yield accounting for only about 2-3% of the
return.

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 Price versus Expected Return
• Typically, an investor is not concerned with the value of a stock.
Rather, an investor would like to know the expected rate of return if
the stock is bought at its current market price.
• Given the price and expected rate of return, investor has to decide if
the expected return compensates for the risk.

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 In-class practice
• In-class practice week 12
• Q1 – Q3
• 30 minutes

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The expected rate of return
of Stockholders and
Company cost of Equity

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 Cash (Investment) & Securities (Financing) flows

INVESTMENT

CASH CASH

STOCKS STOCKS

SHAREHOLDERS CAPITAL MARKET COMPANY

FINANCING

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 Expected rate of return & Cost of
Equity
• Shareholders invest in a company stock to get their expected rate of
returns of their investments  Check the valuation of Preference &
Common stocks
• Companies issue stocks as financing sources, therefore shareholders’
expected rate of return become companies’ cost of capital from
stocks

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 Example
• Assume PG&E issued preferred stock pays an annual dividend of 5%.
The par value of the preferred stock is $100. What is the
shareholders’ expected rate of return? What is the cost of capital of
PG&E preferred stock?
• Answer:
Dividend of preferred stock = 5% x $100 = $5.
Shareholders’ preferred stocks = $5/$100 = 5%
Cost of capital of PG&E preferred stock is 5%

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 Expected Rate of Return of Common
Stockholders

Example: The current market price of stock is $90 and the

stock pays dividend of $1.12 with a growth rate of 13.6%.

Therefore, the cost of common stock for the company is 14.8%

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 Cost of Capital of a company
• As long as company can estimate the cost of each
financing sources (debt & equity), company can
compute the cost of capital for the firm by using the
following equation:

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 Estimating the Cost of Capital
• If we divide the costs of capital into debt and equity portions of
market value of firm, then we can use the above to arrive at
the weighted average cost of capital (WACC) for the firm:

• Debt can be bank loans, bonds, and/or long-term promissory

notes.
• Equity can be preferred stocks, and/or common stocks

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 Example: Weighted-Average Cost of
Capital
The total market value of a firm is $4,000,000 and it has
$300,000 debt. The cost of debt is 6% and the cost of
equity is 10%. What is the weighted-average cost of
capital (WACC)?

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 In-class practice
• In-class practice week 12
• Q4 – Q5
• 30 minutes

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 Homework in group
Submitted on the same day before 23.59PM
1. You are evaluating the purchase of Charbridge, Inc. common stock which currently pays no
dividend and is not expected to do so for many years. Because of rapidly growing sales and profits,
you believe the stock will be worth $51.50 in 3 years. If your required rate of return is 16%, what is the
stock worth today?
A) $59.74
B) $51.25
C) $32.99
D) $0.00 because stocks that do not pay dividends have no value.
2. Little Feet Shoe Co. just paid a dividend of $1.65 on its common stock. This company's dividends are
expected to grow at a constant rate of 3% indefinitely. If the required rate of return on this stock is
11%, compute the current value of per share of LFS stock.
A) $20.63
B) $21.24
C) $15.00
D) $55.00

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3. Acme Consolidated has a return on equity of 12%. If Acme distributes 60% of earnings as
dividends, its expected growth rate will be
A) new 4.80%.
B) 7.20%.
C) 12%.
D) 6%.
4. A firm just paid $2.00 on its common stock and expects to continue paying dividends, which are
expected to grow 5% each year, from now to infinity. If the required rate of return for this stock is 9%,
then the value of the stock is
A) $50.00.
B) $40.00.
C) $54.50.
D) $52.50.

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5. A share of common stock just paid a dividend of $3.25 per share. The expected long-run growth
rate for this stock is 18%. If investors require a rate of return of 24%, what should the price of the
stock be?
A) $57.51
B) $62.25
C) $71.86
D) $63.92
6. Is the following common stock priced correctly? If no, what is the correct price?
Price = $26.25
Required rate of return = 13%
Dividend year 0 = $2.00
Dividend year 1 = $2.10

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Thank you 

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