FINA 1310_1F Handouts 4 (Chapter 7) and Handout 5 (Chapter 8)

Review Exercises with Solutions

Handout 3 (Chapter 7): Questions 3, 8, 10, 12, 20. (p.240-241);

Handout 4 (Chapter 8): Questions 1, 2, 9, 15, 16, 27, 29 (p.272-274)

Solutions to Review Exercises of Handout 3 (Chapter 7)

3. The price of any bond is the PV of the interest payments, plus the PV of the par value. Notice
this problem assumes an annual coupon. The price of the bond will be:
P = €36{[1 – 1/(1 + .032)27]/.032} + €1,000[1/(1 + .032)27]
P = €1,071.60

Financial Calculator
Enter 27 3.2% ±€36 ±€1,000
N I/Y PV PMT FV
Solve for €1,071.60

8. Here we need to find the coupon rate of the bond. All we need to do is to set up the bond
pricing equation and solve for the coupon payment as follows:
P = $987 = C(PVIFA2.65%,29) + $1,000(PVIF2.65%,29)

Solving for the coupon payment, we get:

C = $25.85

Since this is the semiannual payment, the annual coupon payment is:
2 × $25.85 = $51.70

And the coupon rate is the annual coupon payment divided by par value, so:

Coupon rate = $51.70/$1,000

Coupon rate = .0517, or 5.17%

Financial Calculator
Enter 29 5.3%/2 ±$987 $1,000
N I/Y PV PMT FV
Solve for $25.85
$25.85(2)/$1,000 = .0517, or 5.17%

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10. To find the price of this bond, we need to find the present value of the bond’s cash flows. So,
the price of the bond is:
P = $47(PVIFA2.525%,26) + $2,000(PVIF2.525%,26)
P = $1,933.87

Financial Calculator
Enter 26 5.05%/2 ±$94/2 ±$2,000
N I/Y PV PMT FV
Solve for $1,933.87

12. The approximate relationship between nominal interest rates (R), real interest rates (r), and
inflation (h) is:
Rr+h
Approximate r = .046 – .019
Approximate r = .027, or 2.70%

The Fisher equation, which shows the exact relationship between nominal interest rates, real
interest rates, and inflation is:

(1 + R) = (1 + r)(1 + h)
(1 + .046) = (1 + r)(1 + .019)
r = [(1 + .046)/(1 + .019)] – 1
r = .0265, or 2.65%

20. Initially, at a YTM of 6 percent, the prices of the two bonds are:
PJ = $15(PVIFA3%,36) + $1,000(PVIF3%,36) = $672.52
PK = $45(PVIFA3%,36) + $1,000(PVIF3%,36) = $1,327.48

If the YTM rises from 6 percent to 8 percent:

PJ = $15(PVIFA4%,36) + $1,000(PVIF4%,36) = $527.29
PK = $45(PVIFA4%,36) + $1,000(PVIF4%,36) = $1,094.54

The percentage change in price is calculated as:

Percentage change in price = (New price – Original price)/Original price
PJ% = ($527.29 – 672.52)/$672.52 = –.2159, or –21.59%
PK% = ($1,094.54 – 1,327.48)/$1,327.48 = –.1755, or –17.55%

If the YTM declines from 6 percent to 4 percent:

PJ = $15(PVIFA2%,36) + $1,000(PVIF2%,36) = $872.56
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 PK = $45(PVIFA2%,36) + $1,000(PVIF2%,36) = $1,637.22
PJ% = ($872.56 – 672.52)/$672.52 = .2974, or 29.74%
PK% = ($1,637.22 – 1,327.48)/$1,327.48 = .2333, or 23.33%

All else the same, the lower the coupon rate on a bond, the greater is its price sensitivity to
changes in interest rates.

Financial Calculator
20. Initially, at a YTM of 6 percent, the prices of the two bonds are:

PJ
Enter 36 6%/2 ±$30/2 ±$1,000
N I/Y PV PMT FV
Solve for $672.52

PK
Enter 36 6%/2 ±$90/2 ±$1,000
N I/Y PV PMT FV
Solve for $1,327.48

If the YTM rises from 6 percent to 8 percent:

PJ
Enter 36 8%/2 ±$30/2 ±$1,000
N I/Y PV PMT FV
Solve for $527.29
PJ% = ($527.29 – 672.52)/$672.52 = –21.59%

PK
Enter 36 8%/2 ±$90/2 ±$1,000
N I/Y PV PMT FV
Solve for $1,094.54
PK% = ($1,094.54 – 1,327.48)/$1,327.48 = –17.55%

If the YTM declines from 6 percent to 4 percent:

PJ
Enter 36 4%/2 ±$30/2 ±$1,000
N I/Y PV PMT FV
Solve for $872.56
PJ% = ($872.56 – 672.52)/$672.52 = + 29.74%
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PK
Enter 36 4%/2 ±$90/2 ±$1,000
N I/Y PV PMT FV
Solve for $1,637.22
PK% = ($1,637.22 – 1,327.48)/$1,327.48 = + 23.33%

All else the same, the lower the coupon rate on a bond, the greater is its price sensitivity to
changes in interest rates.

Solutions to Review Exercises of Handout 4 (Chapter 8)

The functions you may need to use in the financial calculator for the following questions are simple
ones that you have already learned in the previous handout (chapters). Thus, they are not
presented below.

1. The constant dividend growth model is:

Pt = Dt × (1 + g)/(R – g)

So the price of the stock today is:

P0 = D0(1 + g)/(R – g)
P0 = $3.20(1.04)/(.105 – .04)
P0 = $51.20

The dividend at Year 4 is the dividend today times the FVIF for the growth rate in dividends
and four years, so:
P3 = D3(1 + g)/(R – g)
P3 = D0(1 + g)4/(R – g)
P3 = $3.20(1.04)4/(.105 – .04)
P3 = $57.59

We can do the same thing to find the dividend in Year 16, which gives us the price in Year 15,
so:
P15 = D15(1 + g)/(R – g)
P15 = D0(1 + g)16/(R – g)
P15 = $3.20(1.04)16/(.105 – .04)
P15 = $92.21

There is another feature of the constant dividend growth model: The stock price grows at the
dividend growth rate. So, if we know the stock price today, we can find the future value for
any time in the future for which we want to calculate the stock price. In this problem, we want
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 to know the stock price in three years, and we have already calculated the stock price today.
The stock price in three years will be:

P3 = P0(1 + g)3
P3 = $51.20(1 + .04)3
P3 = $57.59

And the stock price in 15 years will be:

P15 = P0(1 + g)15
P15 = $51.20(1 + .04)15
P15 = $92.21

2. We need to find the required return of the stock. Using the constant growth model, we can
solve the equation for R. Doing so, we find:
R = (D1/P0) + g
R = ($1.87/$37) + .043
R = .0935, or 9.35%

9. We can use the constant dividend growth model, which is:

Pt = Dt × (1 + g)/(R – g)

So the price of each company’s stock today is:

Red stock price = $4.15/(.08 – .04) = $103.75
Yellow stock price = $4.15/(.11 – .04) = $59.29
Blue stock price = $4.15/(.14 – .04) = $41.50

As the required return increases, the stock price decreases. This is a function of the time value
of money: A higher discount rate decreases the present value of cash flows. It is also
important to note that relatively small changes in the required return can have a dramatic
impact on the stock price

15. Here we have a stock that pays no dividends for 10 years. Once the stock begins paying
dividends, it will have a constant growth rate of dividends. We can use the constant growth
model at that point. It is important to remember that the general constant dividend growth
formula is:
Pt = [Dt × (1 + g)]/(R – g)

This means that since we will use the dividend in Year 10, we will be finding the stock price in
Year 9. The dividend growth model is similar to the PVA and the PV of a perpetuity: The
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 equation gives you the PV one period before the first payment. So, the price of the stock in
Year 9 will be:
P9 = D10/(R – g)
P9 = $14/(.115 – .039)
P9 = $184.21

The price of the stock today is the PV of the stock price in the future. We discount the future
stock price at the required return. The price of the stock today will be:
P0 = $184.21/1.1159
P0 = $69.16

16. The price of a stock is the PV of the future dividends. This stock is paying five dividends, so the
price of the stock is the PV of these dividends using the required return. The price of the stock
is:
P0 = $8.75/1.11 + $13.75/1.112 + $18.75/1.113 + $23.75/1.114 + $28.75/1.115
P0 = $65.46

27. We need to find the PE ratio each year, which is:

PE1 = $53.27/$2.35 = 22.67

PE2 = $59.48/$2.47 = 24.08
PE3 = $62.42/$2.78 = 22.45
PE4 = $66.37/$3.04 = 21.83

So, the average PE is:

Average PE = (22.67 + 24.08 + 22.45 + 21.83)/4

Average PE = 22.76

First, we need to find the earnings per share next year, which will be:

EPS1 = EPS0(1 + g)
EPS1 = $3.04(1 + .11)
EPS1 = $3.37

Using the equation to calculate the price of a share of stock with the PE ratio:

P1 = Benchmark PE ratio × EPS1

P1 = 22.76($3.37)
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 P1 = $76.80
29. To find the target price in five years, we first need to find the EPS in five years, which will be:

EPS5 = EPS0(1 + g)5

EPS5 = $3.25(1 + .08)5
EPS5 = $4.78

So, the target stock price in five years is:

P5 = Benchmark PE ratio × EPS5

P5 = 23($4.78)
P5 = $109.83