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CF2 Group 3 Exercise 3

This document contains two corporate finance problems and their solutions. Problem 1 asks about the relationship between bond prices and interest rates, bond prices and yields, and the prices of high-coupon vs low-coupon bonds. Problem 2 calculates the current share price of a company given its dividend growth rates, most recent dividend, and required rate of return. The solutions show that bond prices fall when interest rates rise, bond prices are lower than face value when yields exceed coupons, and yields are lower than coupons when bond prices exceed face value. High-coupon bonds sell at higher prices than low-coupon bonds. For Problem 2, the current share price is calculated to be $78.89.

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28 views7 pages

CF2 Group 3 Exercise 3

This document contains two corporate finance problems and their solutions. Problem 1 asks about the relationship between bond prices and interest rates, bond prices and yields, and the prices of high-coupon vs low-coupon bonds. Problem 2 calculates the current share price of a company given its dividend growth rates, most recent dividend, and required rate of return. The solutions show that bond prices fall when interest rates rise, bond prices are lower than face value when yields exceed coupons, and yields are lower than coupons when bond prices exceed face value. High-coupon bonds sell at higher prices than low-coupon bonds. For Problem 2, the current share price is calculated to be $78.89.

Uploaded by

nguyenngockhaihoan811
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We take content rights seriously. If you suspect this is your content, claim it here.
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CORPORATE FINANCE – TERM 3/2023

GROUP 3 - EXERCISE 3

Question:
Problem 1:
Answer the following questions. In addition, for each answer: construct a simple example to illustrate.
a. If interest rates rise, do bond prices rise or fall?
b. If the bond yield to maturity is greater than the coupon rate, is the price of the bond greater or less than face
value?
c. If the price of a bond exceeds face value, is the yield to maturity greater or less than the coupon?
d. Do high-coupon bonds sell at higher or lower prices than low-coupon bonds?
Problem 2:
Company A has the following information:
- Dividends are expected to grow at a rate of 15% for the next 6 years.
- Then, the growth rate drops to 4% thereafter.
- The company just paid a dividend of $2.65.
Calculate the current share price if the required return is 10%.
Problem 1:
a. If interest rates rise, do bond prices rise or fall?
Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall. And
when interest rates fall, bond prices rise.
Suppose you own a bond that pays a coupon of 5% and has a maturity of 10 years. This means that you will
receive a payment of 5% of the face value of the bond each year for the next 10 years, plus the face value of the
bond at maturity.
If interest rates rise, new bonds will be issued with higher coupon rates. This means that your bond will
become less attractive to investors, since it pays a lower coupon rate. As a result, the price of your bond will fall.
The relationship between bond prices and interest rates can be described by the following equation:
𝐶
𝑃= 𝑡
(1+𝑟)

Suppose that interest rates rise from 5% to 6%. This means that the price of our bond will fall from:
5%
𝑃= 10 = $ 100
(1+0.05)

To:
5%
𝑃= 10 = $ 91. 55
(1+0.06)

→ This represents a decline in the bond price of 8.45%.


b. If the bond yield to maturity is greater than the coupon rate, is the price of the bond greater or less than face
value?
→ If the bond yield to maturity is greater than the coupon rate, the price of the bond will be less than the
face value.
Example:
Face value = $ 1,000
Time to maturity = 15 years
Coupon rate = 6% → C = 1,000 * 6% = $ 60
Yield to maturity (YTM) = 8%
YTM > Coupon rate
−𝑛 −15
1−(1+𝑌𝑇𝑀) 𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 1−(1+0.08) 1,000
→ 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 (𝐵𝑉) = 𝐶 * [ 𝑌𝑇𝑀
]+ 𝑛 = 60 * [ 0.08
]+ 15 = $ 828. 81
(1+𝑌𝑇𝑀) (1+0.08)

→ Bond value < Face value ($ 828.81 < $ 1,000)


c. If the price of a bond exceeds face value, is the yield to maturity greater or less than the coupon?
→ The yield to maturity (YTM) will be less than the coupon rate if the price of a bond is higher than its
face value.
Example:
Considering a bond with a face value of $1,000, a coupon rate of 12%, and a remaining time to maturity of
10 years. Suppose the current market price of the bond is $ 1,300, which is higher than its face value.
Face value = $ 1,000
Coupon rate = 12% → C = 1,000 * 12% = $ 120
Time to maturity: 10 years
Market price = $ 1,300
−𝑛
1−(1+𝑌𝑇𝑀) 𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 (𝐵𝑉) = 𝐶 * [ 𝑌𝑇𝑀
]+ 𝑛
(1+𝑌𝑇𝑀)
−10
1−(1+𝑌𝑇𝑀) 1,000
⇔ 1, 300 = 120 * [ 𝑌𝑇𝑀
]+ 10
(1+𝑌𝑇𝑀)

⇔ 𝑌𝑇𝑀 = 7. 6%
→ Yield to maturity (YTM/R) < Coupon rate (7.6% < 12%)
d. Do high-coupon bonds sell at higher or lower prices than low-coupon bonds?
→ Bonds with a high coupon sell for more money than those with a low coupon. This is due to the
fact that investors find high-coupon bonds to be more alluring due to the higher revenue streams
they offer compared to low-coupon bonds. Due to the increased revenue stream, investors are
therefore willing to pay more for high-coupon bonds.
Example: Consider two bonds with similar characteristics, but one has a high coupon rate of 8%
and the other has a low coupon rate of 4%. The high-coupon bond would sell at a lower price
compared to the low-coupon bond because it offers higher regular interest payments.
Problem 2:
● Dividend for each of the next 6 years (grow at a rate of 15%)
Year 1: Dividend = $ 2.65 x (1 + 15%) = $ 3.05
Year 2: Dividend = $ 3.05 x (1 + 15%) = $ 3.51
Year 3: Dividend = $ 3.51 x (1 + 15%) = $ 4.04
Year 4: Dividend = $ 4.04 x (1 + 15%) = $ 4.65
Year 5: Dividend = $ 4.65 x (1 + 15%) = $ 5.35
Year 6: Dividend = $ 5.35 x (1 + 15%) = $ 6.15
● Dividend for year 7 and beyond (grow at a rate of 4%)
Year 7: Dividend = $ 6.15 x (1 + 4%) = $ 6.4
● 𝑔1 = 15%, 𝑅 = 10%
𝐷1 𝐷2 𝐷3 𝐷4 𝐷5 𝐷6
𝑃0 = (1+𝑅)
+ 2 + 3 + 4 + 5 + 6
(1+𝑅) (1+𝑅) (1+𝑅) (1+𝑅) (1+𝑅)

3.05 3.51 4.04 4.65 5.35 6.15


⇔ 𝑃0 = (1+0.1)
+ 2 + 3 + 4 + 5 + 6
(1+0.1) (1+0.1) (1+0.1) (1+0.1) (1+0.1)

⇔ 𝑃0 = $ 18. 68

● 𝑔2 = 4%, 𝑅 = 10%
𝐷7 6.4
𝑃6 = (𝑅−𝑔2)
= (10%−4%)
= $ 106. 67
𝑃6 106.67
𝑃0 = 6 = 6 = $ 60. 21
(1+𝑅) (1+0.1)

→ The current share price = 18.68 + 60.21 = $ 78.89

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