Derive the inverse relationship between Price and Yield in debt markets using a property-based example where the market price doubles in value but ultimately falls by one third of the initial price and where the initial rental yield is 6%. Include an explanation or commentary along with your calculations and proof.

Derive the inverse relationship between Price and Yield in debt markets using a property-based example where the market price doubles in value but ultimately falls by one third of the initial price and where the initial rental yield is 6%. Include an explanation or commentary along with your calculations and proof.

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter15: Capital Structure Decisions

Section: Chapter Questions

Problem 5MC: What happens to ROE for Firm U and Firm L if EBIT falls to $1,600? What happens if EBIT falls to...

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Which of the following statements is true? A. Yield spread is reflected in the size of the bid-ask spreads. B. Issuer credit ratings, or corporate family ratings, reflect a debt issuer’s overall creditworthiness and typically apply to a firm’s senior secured debt. C. An investor with an investment horizon of 6 years buys a bond with a modified duration of 6.0. if the yield-to-maturity (YTM) is 0.0214, this investment will have no duration gap. D. Compared to long-term duration bonds, short-term duration bonds have narrow bid-ask spreads.
d. If you hold the bonds for one year, and interest rates do not change, what total rate of return will you earn, assuming that you pay the market price? Why is this different from the current yield and YTM?
Your firm has a target debt ratio of 30%. Cost of debt (Rb) is 6%. The risk-free rate is 3% and the expected market risk premium is 6%. Your firm's unlevered (asset) beta is 1. What is the appropriate rate to discount the interest tax shields associated with your debt? Only typed answer
Please answer the following question: The modified duration and convexity of a 6%, 25 year bond selling toyield 9% is 10.62 and 91.46 respectively. If the required yield increasesby 300 basis points from 9% to 12% what is the approximate percentagechange in the price of the bond due toa) duration,b) convexity,c) duration and convexity?d) If the actual change is -26.50%, compare your results from a) and c)which provides a better approximation?
The yield on a firms bond is 8.75% and your economist believes that the cost of common can be estimated using a risk premium of 3.85% over firms own cost of debt. What is the firms cost of common from reinvested earnings?
What happens to ROE for Firm U and Firm L if EBIT falls to $1,600? What happens if EBIT falls to $1,200? What is the after-tax cost of debt? What does this imply about the impact of leverage on risk and return?
Suppose there is a large probability that L will default on its debt. For the purpose of this example, assume that the value of Ls operations is 4 million (the value of its debt plus equity). Assume also that its debt consists of 1-year, zero coupon bonds with a face value of 2 million. Finally, assume that Ls volatility, , is 0.60 and that the risk-free rate rRF is 6%.
Next, we need to calculate MMMs cost of debt. We can use different approaches to estimate it One approach is to take the companys interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in todays market (i.e., if MMMs outstanding bonds are trading at dose to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the companys annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firms various bond issues. A longer-term issues YTM could provide an estimate of the firms current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMMs tax rate (which has averaged around 30% in recent years). What is your estimate of MMMs after-tax cost of debt?
Suppose that an FI holds two loans with the following characteristics. Annual Spread Between Loss to FI Expected Loan Rate and FI=s Annual Given Default Loan Xi Cost of Funds Fees Default Frequency 1 .6 4.5% 2.5% 30% 3% ρ12 = -.4 2 .4 3.5% 2% 20% 5% Calculate of the return and risk on the two-asset portfolio using KMV Portfolio Manager.
Complete the following table by identifying the appropriate corresponding variables used in the equation. Unknown Variable Name Variable Value A B $1,000 C Semiannual required return Based on this equation and the data, it is to expect that Ella’s potential bond investment is currently exhibiting an intrinsic value equal to $1,000. Now, consider the situation in which Ella wants to earn a return of 11%, but the bond being considered for purchase offers a coupon rate of 8.00%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond’s intrinsic value to the nearest whole dollar, then its intrinsic value of (rounded to the nearest whole dollar) is its par value, so that the bond is . Given your computation and conclusions, which of the following statements is true? A bond should trade at par when the coupon rate is less than Ella’s required return.…
Assume for parts (a) to (h) that the Capital Asset Pricing Model holds. The marketportfolio has an expected return of 5%. Stock A’s return has a market beta of 1.5, anexpected value of 7% and a standard deviation of 10%. Stock B’s return has amarket beta of 0.5 and a standard deviation of 20%. The correlation between stockA’s and stock B’s return is 0.5.Required:a) Explain the term ‘capital asset pricing model.’b) What is the risk-free rate?c) What is the expected return on stock B?d) Draw a graph with expected return on the y-axis and beta on the x-axis. Indicate the approximate position of the risk-free asset, the market portfolio and stocks A and B on this graph. Draw the line, which connects these four points.e) Explain the term ‘Securities Market Line’, and what is the slope of the SML for this economy?f) Consider a portfolio with a weight of 50% in stock A and 50% in stock B. What are its variance and expected return?g) Where would under-priced and over-priced securities plot on…
Suppose you are given the following inputs for the Fama-Frech-3-Factor model. Required Return for Stock i: bi=0.8, kRF=8%, the market risk premium is 6%, ci=-0.6, the expected value for the size factor is 5%, di=-0.4, and the expected value for the book-to-market factor is 4%. Task: Estimate the required rate of return of this asset using the Capital asset pricing model and compare it with the Fama-French-3-factor model.