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All Textbook Solutions for Fundamentals Of Financial Management, Concise Edition (mindtap Course List)

What is a firms intrinsic value? Its current stock price? Is the stocks true long-run value more closely related to its intrinsic value or to its current price?When is a stock said to be in equilibrium? Why might a stock at any point in time not be in equilibrium?3Q Is it better for a firms actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoints of stockholders in general and a CEO who is about to exercise a million dollars in options and then retire? Explain.5Q 6Q Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action increases a firms stock price from a current level of 20 to 25 in 6 months and then to 30 in 5 years, but another action keeps the stock at 20 for several years but then increases it to 40 in 5 years, which action would be better? Think of some specific corporate actions that have these general tendencies.8Q The president of Southern Semiconductor Corporation (SSC) made this statement in the companys annual report SSCs primary goal is to increase the value of our common stockholders' equity. Later in the report the following announcements were made: a. The company contributed 1.5 million to the symphony orchestra in Birmingham, Alabama, its headquarters city. b. The company is spending 5500 million to open a new plant and expand operations in China. No profits will be produced by the Chinese operation for 4 years, so earnings will be depressed during this period versus what they would have been had the decision been made not to expand in China. c. The company holds about half of its assets in the form of U.S. Treasury bonds, and it keeps these funds available for use in emergencies. In the future, though, SSC plans to shift its emergency funds from Treasury bonds to common stocks. Discuss how SSCs stockholders might view each of these actions and how the actions might affect the stock price.10Q 11Q 12Q 13Q Bedrock Company has 70 million in debt and 30 million in equity. The debt matures in 1 year and has a 10% interest rate, so the company is promising to pay back 77 million to its debtholders 1 year from now. The company is considering two possible investments, each of which will require an upfront cost of 100 million. Each investment will last for 1 year, and the payoff from each investment depends on the strength of the overall economy. There is a 50% chance that the economy will be weak and a 50% chance it will be strong. Here are the expected payoffs (all dollars are in millions) from the two investments: Note that the two projects have the same expected payoff, but Project H has higher risk. The debtholders always get paid first and the stockholders receive any money that is available after the debtholders have been paid. Assume that if the company doesnt have enough funds to pay off its debtholders 1 year from now, then Bedrock will declare bankruptcy. If bankruptcy is declared, the debtholders will receive all available funds, and the stockholders will receive nothing. a. Assume that the company selects Investment L. What is the expected payoff to the firms debtholders? What is the expected payoff to the firms stockholders? b. Assume that the company selects Investment H. What is the expected payoff to the firms debtholders? What is the expected payoff to the firms stockholders? c. Would the debtholders prefer that the companys managers select Project L or Project H? Briefly explain your reason. d. Explain why the companys managers, acting on behalf of the stockholders, might select Project H, even though it has greater risk. e. What actions can debtholders take to protect their interests?How does a cost-efficient capital market help reduce the prices of goods and services?Describe the different ways in which capital can be transferred from suppliers of capital to those who are demanding capital.3Q Indicate whether the following instruments are examples of money market or capital market securities. a. U.S. Treasury bills b. Long-term corporate bonds c. Common stocks d. Preferred stocks e. Dealer commercial paper 5Q What types of changes have financial markets experienced during the last two decades? Have they been perceived as positive or negative changes? Explain.Differentiate between dealer markets and stock markets that have a physical location.Identify and briefly compare the two leading stock exchanges in the United States today.Briefly explain what is meant by the term efficiency continuum.10Q FINANCIAL MARKETS AND INSTITUTIONS Assume that you recently graduated with a degree in finance and have just reported to work as an investment adviser at the brokerage firm of Smyth Barry Co. Your first assignment is to explain the nature of the U.S. financial markets to Michelle Varga, a professional tennis player who recently came to the United States from Mexico. Varga is a highly ranked tennis player who expects to invest substantial amounts of money through Smyth Barry. She is very bright; therefore, she would like to understand in general terms what will happen to her money. Your boss has developed the following questions that you must use to explain the U.S. financial system to Varga. a. What are the three primary ways in which capital is transferred between savers and borrowers? Describe each one. b. What is a market? Differentiate between the following types of markets: physical asset markets versus financial asset markets, spot markets versus futures markets, money markets versus capital markets, primary markets versus secondary markets, and public markets versus private markets. c. Why are financial markets essential for a healthy economy and economic growth? d. What are derivatives? How can derivatives be used to reduce risk? Can derivatives be used to increase risk? Explain. e. Briefly describe each of the following financial institutions: investment banks, commercial banks, financial services corporations, pension funds, mutual funds, exchange traded funds, hedge funds, and private equity companies. f. What are the two leading stock markets? Describe the two basic types of stock markets. g. If Apple Computer decided to issue additional common stock, and Varga purchased 100 shares of this stock from Smyth Barry, the underwriter, would this transaction be a primary or a secondary market transaction? Would it make a difference if Varga purchased previously outstanding Apple stock in the dealer market? Explain. h. What is an initial public offering (IPO)? i. What does it mean for a market to be efficient? Explain why some stock prices may be more efficient than others. j. After your consultation with Michelle, she wants to discuss these two possible stock purchases: 1. While in the waiting room of your office, she overheard an analyst on a financial TV network say that a particular medical research company just received FDA approval for one of its products. On the basis of this hot information, Michelle wants to buy many shares of that companys stock. Assuming the stock market is highly efficient, what advice would you give her? 2. She has read a number of newspaper articles about a huge IPO being carried out by a leading technology company. She wants to purchase as many shares in the IPO as possible and would even be willing to buy the shares in the open market immediately after the issue. What advice do you have for her? k. How does behavioral finance explain the real-world inconsistencies of the efficient markets hypothesis (EMH)?1Q Who are some of the basic users of financial statements, and how do they use them?If a typical firm reports 20 million of retained earnings on its balance sheet, could its directors declare a 20 million cash dividend without having any qualms about what they were doing? Explain your answer.Explain the following statement: Although the balance sheet can be thought of as a snapshot of a firms financial position at a point in time, the income statement reports on operations over a period of time.5Q 6Q 7Q 8Q How are managements actions incorporated in EVA and MVA? How are EVA and MVA interconnected?10Q 11Q How does the deductibility of interest and dividends by the paying corporation affect the choice of financing (i.e., the use of debt versus equity)?BALANCE SHEET The assets of Dallas Associates consist entriely of current assets and net plant and equipment. The firm has total assets of 25 million and net plant and equipment equals 2 million. It has notes payable of 150.000, long-term debt of 750,000, and total common equity of 15 million. The firm does have accounts payable and accruals on its balance sheet the firm only finances with debt and common equity, so it has no preferred stock on its balance sheet. a. What is the companys total debt? b. What is the amount of total liabilities and equity that appears on the firms balance sheet? c. What is the balance of current assets on the firms balance sheet? d. What is the balance of current liabilities on the firms balance sheet? e. What is the amount of accounts payable and accruals on its balance sheet? (Him: Consider this as a single line item on the firms balance sheet.) f. What is the firms net working capital? g. What is the firms net operating working capital? h. What is the explanation for the difference in your answers to parts f and g?INCOME STATEMENT Byron Books Inc. recently reported 15 million of net income. Its EBIT was 20.8 million, and its tax rate was 25%. What was its interest expense? (Hint: Write out the headings for an income statement, and fill in the known values. Then divide 15 million of net income by (1 T) = 0.75 to find the pretax income. The difference between EBIT and taxable income must be interest expense. Use this same procedure to complete similar problems.)3P 4P 5P MVA Over the years. Masterson Corporations stockholders have provided 34,000,000 of capital when they purchased now issues of stock and allowed management to retain some of the firms earnings. The firm now has 2,000,000 shares of common stock outstanding, and the shares sell at a price of 28 per share. How much value has Mastersons management added to stockholder wealth over the years, that is, what is Mastersons MVA?EVA Barton Industries has operating income for the year of 3,500,000 and a 25% tax rate. Its total invested capital is 20,000,000 and its after-tax percentage cost of capital is 8%. What is the firms EVA?PERSONAL TAXES Susan and Stan Britton are a married couple who file a joint income tax return, where the tax rates an? based on the tax tables presented in the chapter. Assume that their taxable income this year was 375,000. a. What is their federal tax liability? b. What is their marginal tax rate? c. What is their average tax rate?9P STATEMENT OF STOCKHOLDERS EQUITY Electronics World Inc. paid out 22.4 million in total common dividends and reported 144.7 million of retained earnings at year-end. The prior years retained earnings were 955 million. What was the net income? Assume that all dividends declared were actually paid.EVA For 2019, Gourmet Kitchen Products reported 22 million of sales and 19 million of operating costs (including depreciation). The company has 15 million of total invested capital. Its after-tax cost of capital is 10%, and its federal-plus-state income tax rate was 25%. What was the firms economic value added (EVA), that is, how much value did management add to stockholders wealth during 2019?12P 13P 14P INCOME STATEMENT Edmonds Industries is forecasting the following income statement: The CEO would like to see higher sales and a forecasted net income of 3,000,000. Assume that operating costs (excluding depreciation and amortization) are 55% of sales and that depreciation and amortization and interest expenses will increase by 6%. The tax rate, which is 25%, will remain the same. (Note that while the tax rate remains constant, the taxes paid will change.) What level of sales would generate 3,000,000 in net income?16P 17P PERSONAL TAXES Mary Jams is a single individual who is working on filing her tax return for the previous year. She has assembled the following relevant information: She received 82,000 in salary. She received 12,000 of dividend income. She received 5,000 of interest income on Home Depot bonds. She received 22,000 from the sale of Disney stock that was purchased 2 years prior to the sale at a cost of 9,000. She received 10,000 from the sale of Google stock that was purchased 6 months prior to the sale at a cost of 7,500. Mary only has allowable itemized deductions of 7,500, so she will take the standard deduction of 12,000. The standard deduction is subtracted from her gross income from her gross income to determine her taxable income. Assume that her tax rates are based on the tax tables presented in the chapter. a. What is Marys federal tax liability? b. What is her marginal tax rate? c. What is her average tax rate?19SP 20IC Financial ratio analysis is conducted by three main groups of analysts: credit analysts, stock analysts, and managers. What is the primary emphasis of each group, and how would that emphasis affect the ratios on which they focus?2Q Over the past year, M.D. Ryngaert Co. had an increase in its current ratio and a decline in its total assets turnover ratio. However, the companys sales, cash and equivalents, DSO, and fixed assets turnover ratio remained constant. What balance sheet accounts must have changed to produce the indicated changes?Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between the turnover ratios, profit margins, and DuPont equations for a grocery chain and a steel company?How does inflation distort ratio analysis comparisons for one company over time (trend analysis) and for different companies that are being compared? Are only balance sheet items or both balance sheet and income statement items affected?If a firms ROE is low and management wants to improve it, explain how using more debt might help.Give some examples that illustrate how (a) seasonal factors and (b) different growth rates might distort a comparative ratio analysis. How might these problems be alleviated?8Q Suppose you were comparing a discount merchandiser with a high-end merchandiser. Suppose further that both companies had identical ROEs. If you applied the DuPont equation to both firms, would you expect the three components to be the same? for each company? If not, explain what balance sheet and income statement items might lead to the component differences.10Q Differentiate between ROE and ROIC.12Q DAYS SALES OUTSTANDING Baxley Brothers has a DSO of 23 days, and its annual sales are 3,650,000. What is its accounts receivable balance? Assume that it uses a 365-day year.DEBT TO CAPITAL RATIO Kayes Kitchenware has a market/book ratio equal to 1. Its stock price is 12 per share and it has 4.8 million shares outstanding. The firms total capital is 110 million and it finances with only debt and common equity. What is its debt-to-capital ratio?DuPONT ANALYSIS Hendersons Hardware has an ROA of 11%, a 6% profit margin, and an ROE of 23%. What is its total assets turnover? What is its equity multiplier?MARKET/BOOK AND EV/EBITDA RATIOS Edelman Engines has 17 billion in total assets of which cash and equivalents total 100 million. Its balance sheet shows 1.7 billion in current liabilitiesof which the notes payable balance totals 1 billion. The firm also has 102 billion in long-term debt and 5.1 billion in common equity. It has 300 million shares of common stock outstanding, and its stock price is 20 per share. The firm's EBITDA totals 1.368 billion. Assume the firm's debt is priced at par, so the market value of its debt equals its book value. What are Edelman's market/book and its EV/EBITDA ratios?PRICE/EARNINGS RATIO A company has an EPS of 2.40, a book value per share of 21.84, and a market/book ratio of 2.7. What is its P/E ratio?DuPONT AND ROE A firm has a profit margin of 3% and an equity multiplier of 1.9. Its sales are 150 million, and it has total assets of 60 million. What is its ROE?ROE AND ROIC Baker Industriess net income is 24,000, its interest expense is 5,000, and its tax rate is 25%. Its notes payable equals 27,000, long-term debt equals 75,000, and common equity equals 250,000. The firm finances with only debt and common equity, so it has no preferred stock. What are the firms ROE and ROIC?DuPONT AND NET INCOME Precious Metal Mining has 17 million in sales, its ROE is 17%, and its total assets turnover is 3.2 . Common equity on the firms balance sheet is 50% of its total assets. What is its net income?9P M/B, SHARE PRICE, AND EV/EBITDA You are given the following information: Stockholders' equity as. reported on the firm's balance sheet = 6.5 billion, price/earnings ratio = 9, common shares outstanding = 180 million, and market/book ratio = 2.0. The firm's market value of total debt is 7 billion, the firm has cash and equivalents totaling 250 million, and the firms EBITDA equals 2 billion. What is the price of a share of the company's common stock? What is the firm's EV/EBITDA?RATIO CALCULATIONS Assume the following relationships for the Caulder Corp.: Sales/Total assets 1.3 Return on assets (ROA) 4.0% Return on equity (ROE) 8.0%12P TIE AND ROIC RATIOS The W.C Pruett Corp. has 600,000 of interest-bearing debt outstanding, and it pays an annual interest rate of 7%. In addition, it has 600,000 of common stock on its balance sheet. It finances with only debt and common equity, so it has no preferred stock. Its annual sales are 2.7 million, its average tax rate is 25%, and its profit margin is 7%. What are its TIE ratio and its return on invested capital (ROIC)?RETURN ON EQUITY Pacific Packagings ROE last year was only 5%, but its management has developed a new operating plan that calls for a debt-to capital ratio of 40%, which will result in annual interest charges of 561,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of 1,870,000 on sales of 17,000,000, and it expects to have a total assets turnover ratio of 2.1. Under these conditions, the tax rate will be 25%. If the changes are made, what will be the companys return on equity?RETURN ON EQUITY AND QUICK RATIO Lloyd Inc. has sales of 200,000, a net income of 15,000, and the following balance sheet: The new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industry average, 25, without affecting sales or net income. If inventories are sold and not replaced (thus reducing the current ratio to 25); if the funds generated are used to reduce common equity (stock can be repurchased at book value); and if no other changes occur, by how much will the ROE change? What will be the firms new quick ratio?16P CONCEPTUAL: RETURN ON EQUITY Which of the following statements is most correct? (Hint: Work Problem 4-16 before answering 4-17, and consider the solution setup for 4-16 as you think about 4-17.) a. If a firms expected basic earning power (BEP) is constant for all of its assets and exceeds the interest rate on its debt, adding assets and financing them with debt will raise the firms expected return on common equity (ROE). b. The higher a firms tax rate, the lower its BEP ratio, other things held constant. c. The higher the interest rate on a firms debt, the lower its BEP ratio, other things held constant. d. The higher a firms debt ratio, the lower its BEP ratio, other things held constant. e. Statement a is false, but statements b, c, and d are true.TIE RATIO MPI Incorporated has 6 billion in assets, and its tax rate is 25%. Its basic earning power (BEP) ratio is 11%, and its return on assets (ROA) is 6%. What is MPIs times-interest-earned (TIE) ratio?CURRENT RATIO The Stewart Company has 2,392,500 in current assets and 1,076,625 in current liabilities. Its initial inventory level is 526,350, and it will raise funds as additional notes payable and use them to increase inventory. How much can its short-term debt (notes payable) increase without pushing its current ratio below 2.0?DSO AND ACCOUNTS RECEIVABLE Ingraham Inc. currently has 205,000 in accounts receivable, and its days sales outstanding (DSO) is 71 days. It wants to reduce its DSO to 20 days by pressuring more of its customers to pay their bills on time. If this policy is adopted, the companys average sales will fall by 15%. What will be the level of accounts receivable following the change? Assume a 365-day year.P/E AND STOCK PRICE Ferrell Inc. recently reported net income of 8 million. It has 540,000 shares of common stock, which currently trades at 21 a share. Ferrell continues to expand and anticipates that 1 year from now, its net income will be 13.2 million. Over the next year, it also anticipates issuing an additional 81,000 shares of stock so that 1 year from now it will have 621,000 shares of common stock. Assuming Ferrells price/earnings ratio remains at its current level, what will be its stock price 1 year from now?22P RATIO ANALYSIS Data for Barry Computer Co. and its industry averages follow. The firms debt is priced at par, so the market value of its debt equals its book value. Since dollars are in thousands, number of shares are shown in thousands too. a. Calculate the indicated ratios for Barry b. Construct the DuPont equation for both Barry and the industry. c. Outline Barrys strengths and weaknesses as revealed by your analysis. d. Suppose Barry had doubled its sales as well as its inventories, accounts receivable, and common equity during 2019. How would that information affect the validity of your ratio analysis? (Hint: Think about averages and the effects of rapid growth on ratios if averages are not used. No calculations are needed.) Barry Computer Company: Balance Sheet as of December 31, 2019 (in Thousands) Barry Computer Company: Income Statement for Year Ended December 31, 2019 (in Thousands) aCalculation is based on 365-day year.DuPONT ANALYSIS A firm has been experiencing low profitability in recent years. Perform an analysis of the firms financial position using the DuPont equation. The firm has no lease payments but has a 2 million sinking fund payment on its debt. The most recent industry average ratios and the firms financial statements are as follows: Industry Average Ratios aCalculate is based on 365-day year. Balance Sheet as of December 31, 2019 (millions of dollars) Income Statement for Year Ended December 31, 2019 (millions of dollars) a. Calculate the ratios you think would be useful in this analysis. b. Construct a DuPont equation, and compare the companys ratios to the industry average ratios. c. Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits? d. Which specific accounts seem to be most out of line relative to other firms in the industry? e. If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the year, how might that affect the validity of your ratio analysis? How might you correct for such potential problems?25SP 26IC CONDUCTING A FINANCIAL RATIO ANALYSIS ON HP INC. Use online resources to work on this chapters questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions. In Chapter 3, we looked at Dunkin Brands financial statements. In this chapter, we will use a financial Internet website, www.morningstar.com, to analyze HP Inc., a computer hardware company. Once on the website, you simply enter HP Inc.s ticker symbol (HPQ) to obtain the financial information needed. We will also perform a trend analysis, where we evaluate changes in key ratios over time. Through the Morningstar website, you can find the firms financials (Income Statement, Balance Sheet, and Cash Flow) on an annual or quarterly basis for the five most recent time periods. In addition, the site contains Key Ratios (Profitability, Growth, Cash Flow, Financial Health, and Efficiency) for 10 years. We will use the Key Ratios on this site to conduct the firms trend analysis. (At the bottom of the screen you will see that you can click Glossary to find definitions for the different ratios. For example, Morningstars Financial Leverage ratio is the same as the Equity multiplier that we use in the textbook.) Looking at Morningstars Financial Health ratios, what has happened to HPs liquidity position over the past 10 years?CONDUCTING A FINANCIAL RATIO ANALYSIS ON HP INC. Use online resources to work on this chapters questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions. In Chapter 3, we looked at Dunkin Brands financial statements. In this chapter, we will use a financial Internet website, www.morningstar.com, to analyze HP Inc., a computer hardware company. Once on the website, you simply enter HP Inc.s ticker symbol (HPQ) to obtain the financial information needed. We will also perform a trend analysis, where we evaluate changes in key ratios over time. Through the Morningstar website, you can find the firms financials (Income Statement, Balance Sheet, and Cash Flow) on an annual or quarterly basis for the five most recent time periods. In addition, the site contains Key Ratios (Profitability, Growth, Cash Flow, Financial Health, and Efficiency) for 10 years. We will use the Key Ratios on this site to conduct the firms trend analysis. (At the bottom of the screen you will see that you can click Glossary to find definitions for the different ratios. For example, Morningstars Financial Leverage ratio is the same as the Equity multiplier that we use in the textbook.) Looking at Morningstars Financial Health ratios, what has happened to HPs financial leverage position (looking at both its financial leverage and debt/equity ratios) over the past 10 years?CONDUCTING A FINANCIAL RATIO ANALYSIS ON HP INC. Use online resources to work on this chapters questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions. In Chapter 3, we looked at Dunkin Brands financial statements. In this chapter, we will use a financial Internet website, www.morningstar.com, to analyze HP Inc., a computer hardware company. Once on the website, you simply enter HP Inc.s ticker symbol (HPQ) to obtain the financial information needed. We will also perform a trend analysis, where we evaluate changes in key ratios over time. Through the Morningstar website, you can find the firms financials (Income Statement, Balance Sheet, and Cash Flow) on an annual or quarterly basis for the five most recent time periods. In addition, the site contains Key Ratios (Profitability, Growth, Cash Flow, Financial Health, and Efficiency) for 10 years. We will use the Key Ratios on this site to conduct the firms trend analysis. (At the bottom of the screen you will see that you can click Glossary to find definitions for the different ratios. For example, Morningstars Financial Leverage ratio is the same as the Equity multiplier that we use in the textbook.) Looking at Morningstars Profitability ratios, what has happened to HPs profit margin (net margin %) over the past 10 years? What has happened to its return on assets (ROA) and return on equity (ROE) over the past 10 years?CONDUCTING A FINANCIAL RATIO ANALYSIS ON HP INC. Use online resources to work on this chapters questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions. In Chapter 3, we looked at Dunkin Brands financial statements. In this chapter, we will use a financial Internet website, www.morningstar.com, to analyze HP Inc., a computer hardware company. Once on the website, you simply enter HP Inc.s ticker symbol (HPQ) to obtain the financial information needed. We will also perform a trend analysis, where we evaluate changes in key ratios over time. Through the Morningstar website, you can find the firms financials (Income Statement, Balance Sheet, and Cash Flow) on an annual or quarterly basis for the five most recent time periods. In addition, the site contains Key Ratios (Profitability, Growth, Cash Flow, Financial Health, and Efficiency) for 10 years. We will use the Key Ratios on this site to conduct the firms trend analysis. (At the bottom of the screen you will see that you can click Glossary to find definitions for the different ratios. For example, Morningstars Financial Leverage ratio is the same as the Equity multiplier that we use in the textbook.) Looking at Morningstars Efficiency ratios, how well has it managed its assets (as measured by days sales outstanding, inventory turnover, fixed assets turnover, and total assets turnover) over the past 10 years?1Q Explain whether the following statement is true or false: 100 a year for 10 years is an annuity; but 5100 in Year 1, 200 in Year 2, and 400 in Years 3 through 10 does not constitute an annuity. However, the second series contains an annuity.If a firms earnings per share grew from 1 to 2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain. (Hint: If you arent sure, plug in some numbers and check it out.)Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain.5Q 6Q Banks and other lenders are required to disclose a rate called the APR. What is this rate? Why did Congress require that it be disclosed? Is it the same as the effective annual rate? If you were comparing the costs of loans from different lenders, could you use their APRs to determine the loan with the lowest effective interest rate? Explain.8Q FUTURE VALUE If you deposit 2,000 in a bank account that pays 6% interest annually, how much will be in your account after 5 years?PRESENT VALUE What is the present value of a security that will pay 29,000 in 20 years if securities of equal risk pay 5% annually?FINDING THE REQUIRED INTEREST RATE Your parents will retire in 19 years. They currently have 350,000 saved, and they think they will need 800,000 at retirement. What annual interest rate must they earn to reach their goal, assuming they dont save any additional funds?TIME FOR A LUMP SUM TO DOUBLE If you deposit money today in an account that pays 4% annual interest, how long will it take to double your money?TIME TO REACH A FINANCIAL GOAL You have 33,556.25 in a brokerage account, and you plan to deposit an additional 5,000 at the end of every future year until your account totals 220,000. You expect to earn 12% annually on the account. How many years will it take to reach your goal?6P PRESENT AND FUTURE VALUES OF A CASH FLOW STREAM An investment will pay 150 at the end of each of the next 3 years, S250 at the end of Year 4, 300 at the end of Year 5, and 500 at the end of Year 6. If other investments of equal risk earn 11% annually, what is its present value? Its future value?LOAN AMORTIZATION AND EAR You want to buy a car, and a local bank will lend you 40,000. The loan will be fully amortized over 5 years (60 months), and the nominal interest rate will be 8% with interest paid monthly. What will be the monthly loan payment? What will be the loans EAR?9P 10P GROWTH RATES Sawyer Corporations 2018 sales were 5 million. Its 2013 sales were 2.5 million. a. At what rate have sales been growing? b. Suppose someone made this statement: Sales doubled in 5 years. This represents a growth of 100% in 5 years; so dividing 100% by 5, we find the growth rate to be 20% per year/ Is the statement correct?EFFECTIVE RATE OF INTEREST Find the interest rates earned on each of the following: a. You borrow 720 and promise to pay back 792 at the end of 1 year. b. You lend 720 and the borrower promises to pay you 792 at the end of 1 year. c. You borrow 65,000 and promise to pay back 98,319 at the end of 14 years. d. You borrow 15,000 and promise to make payments of 4,058.60 at the end of each year for 5 years.13P FUTURE VALUE OF AN ANNUITY Find the future values of these ordinary annuities. Compounding occurs once a year. a. 500 per year for 8 years at 14% b. 250 per year for 4 years at 7% c. 700 per year for 4 years at 0% d. Rework parts a, b, and c assuming they are annuities due.PRESENT VALUE OF AN ANNUITY Find the present values of these ordinary annuities. Discounting occurs once a year. a. 600 per year for 12 years at 8% b. 300 per year for 6 years at 4% c. 500 per year for 6 years at 0% d. Rework parts a, b, and c assuming they are annuities due.16P EFFECTIVE INTEREST RATE You borrow 230,000; the annual loan payments are 20,430.31 for 30 years. What interest rate are you being charged?18P FUTURE VALUE OF AN ANNUITY Your client is 26 years old. She wants to begin saving for retirement, with the first payment to come one year from now. She can save 8,000 per year, and you advise her to invest it in the stock market, which you expect to provide an average return of 10% in the future. a. If she follows your advice, how much money will she have at 65? b. How much will she have at 70? c. She expects to live for 20 years if she retires at 65 and for 15 years if she retires at 70. If her investments continue to earn the same rate, how much will she be able to withdraw at the end of each year after retirement at each retirement age?PV OF A CASH FLOW STREAM A rookie quarterback is negotiating his first NFL contract. His opportunity cost is 7%. He has been offered three possible 4-year contracts. Payments are guaranteed, and they would be made at the end of each year. Terms of each contract are as follows: As his adviser, which contract would you recommend that he accept?EVALUATING LUMP SUMS AND ANNUITIES Kristina just won the lottery, and she must choose among three award options. She can elect to receive a lump sum today of 62 million, to receive 10 end-of-year payments of 95 million, or to receive 30 end-of-year payments of 5.6 million. a. If she thinks she can earn 7% annually, which should she choose? b. If she expects to earn 8% annually, which is the best choice? c. If she expects to earn 9% annually, which option would you recommend? d. Explain how interest rates influence her choice.22P 23P PRESENT VALUE FOR VARIOUS DISCOUNTING PERIODS Find the present value of 500 due in the future under each of these conditions: a. 12% nominal rate, semiannual compounding, discounted back 5 years b. 12% nominal rate, quarterly compounding, discounted back 5 years c. 12% nominal rate, monthly compounding, discounted back 1 year d. Why do the differences in the PVs occur?25P PV AND LOAN ELIGIBILITY You have saved 4,000 for a down payment on a new car. The largest monthly payment you can afford is 350. The loan will have a 12% APR based on end-of-month payments. What is the most expensive car you can afford if you finance it for 48 months? For 60 months?27P 28P 29P 30P REQUIRED LUMP SUM PAYMENT Starting next year, you will need 5,000 annually for 4 years to complete your education. (One year from today you will withdraw the first 5,000.) Your undo deposits an amount today in a bank paying 6% annual interest, which will provide the needed 5,000 payments. a. How large must the deposit be? b. How much will be in the account immediately after you make the first withdrawal?REACHING A FINANCIAL GOAL Six years from today you need 10,000. You plan to deposit 1,500 annually, with the first payment to be made a year from today, in an account that pays a 5% effective annual rate. Your last deposit, which will occur at the end of Year 6, will be for less than 1,500 if less is needed to reach 10,000. How large will your last payment be?FV OF UNEVEN CASH FLOW You want to buy a house within 3 years, and you are currently saving for the down payment. You plan to save 9,000 at the end of the first year, and you anticipate that your annual savings will increase by 5% annually thereafter. Your expected annual return is 8%. How much will you have for a down payment at the end of Year 3?AMORTIZATION SCHEDULE a. Set up an amortization schedule for a 19,000 loan to be repaid in equal installments at the end of each of the next 3 years. The interest rate is 8% compounded annually. b. What percentage of the payment represents interest and what percentage represents principal for each of the 3 years? Why do these percentages change over time?AMORTIZATION SCHEDULE WITH A BALLOON PAYMENT You want to buy a house that costs 140,000. You have 14,000 for a down payment, but your credit is such that mortgage companies will not lend you the required 126,000. However, the realtor persuades the seller to take a 126,000 mortgage (called a seller take-back mortgage) at a rate of 5%, provided the loan is paid off in full in 3 years. You expect to inherit 140,000 in 3 years; but right now all you have is 14,000, and you can afford to make payments of no more than 22,000 per year given your salary. (The loan would call for monthly payments, but assume end-of-year annual payments to simplify things.) a. If the loan was amortized over 3 years, how large would each annual payment be? Could you afford those payments? b. If the loan was amortized over 30 years, what would each payment be? Could you afford those payments? c. To satisfy the seller, the 30-year mortgage loan would be written as a balloon note, which means that at the end of the third year, you would have to make the regular payment plus the remaining balance on the loan. What would the loan balance be at the end of Year 3, and what would the balloon payment be?36P PAYING OFF CREDIT CARDS Simon recently received a credit card with an 18% nominal interest rate. With the card, he purchased an Apple iPhone 7 for 372.71. The minimum payment on the card is only 10 per month. a. If Simon makes the minimum monthly payment and makes no other charges, how many months will it be before he pays off the card? Round to the nearest month. b. If Simon makes monthly payments of 35, how many months will it be before he pays off the debt? Round to the nearest month. c. How much more in total payments will Simon make under the 10-a-month plan than under the 35-a-month plan? Make sure you use three decimal places for N.38P 39P 40P 41SP 42IC 1Q 2Q Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or a short-term basis? Why?4Q Suppose a new process was developed that could be used to make oil out of seawater. The equipment required is quite expensive; but it would in time lead to low prices for gasoline, electricity, and other types of energy. What effect would this have on interest rates?6Q It is a fact that the federal government (1) encouraged the development of the savings and loan industry, (2) virtually forced the industry to make long-term fixed-interest-rate mortgages, and (3) forced the savings and loans to obtain most of their capital as deposits that were withdrawable on demand. a. Would the savings and loans have higher profits in a world with a normal or an inverted yield curve? Explain your answer. b. Would the savings and loan industry be better off if the individual institutions sold their mortgages to federal agencies and then collected servicing fees or if the institutions held the mortgages that they originated?Suppose interest rates on Treasury bonds rose from 5% to 9% as a result of higher interest rates in Europe. What effect would this have on the price of an average companys common stock?9Q Suppose you have noticed that the slope of the corporate yield curve has become steeper over the past few months. What factors might explain the change in the slope?YIELD CURVES Assume that yields on U.S. Treasury securities were as follows: Term Rate 6 months 4.69% 1 year 5.49 2 years 5.66 3 years 5.71 4 years 5.89 5 years 6.05 10 years 6.12 20 years 6.64 30 years 6.76 a. Plot a yield curve based on these data. b. What type of yield curve is shown? c. What information does this graph tell you? d. Based on this yield curve, if you needed to borrow money for longer than 1 year, would it make sense for you to borrow short term and renew the loan or borrow Long term? Explain.REAL RISK-FREE RATE You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.8%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums: Inflation premium = 3.25% Liquidity premium = 0.6% Maturity risk premium = 1.85% Default risk premium = 2.15% On the basis of these data, what is the real risk-free rate of return?3P DEFAULT RISK PREMIUM A Treasury bond that matures in 10 years has a yield of 5.75%. A 10-ycar corporate bond has a yield of 8.75%. Assume that the liquidity premium on the corporate bond is 0.35%. What is the default risk premium on the corporate bond?MATURITY RISK PREMIUM The real risk-free rate is 2.5% and inflation is expected to be 2.75% for the next 2 years. A 2-year Treasury security yields 5.55%. What is the maturity risk premium for the 2-year security?INFLATION CROSS-PRODUCT An analyst is evaluating securities in a developing nation where the inflation rate is very high. As a result, the analyst has been warned not to ignore the cross-product between the real rate and inflation. If the real risk-free rate is 5% and inflation is expected to be 18% each of the next 4 years, what is the yield on a 4-year security with no maturity, default, or liquidity risk? (Hint: Refer to The Links Between Expected Inflation and Interest Rates: A Closer Look on page 211.)EXPECTATIONS THEORY One-year Treasury securities yield 4.85%. The market anticipates that 1 year from now, 1-year Treasury securities will yield 5.2%. If the pure expectations theory is correct, what is the yield today for 2-year Treasury securities? Calculate the yield using a geometric average.8P 9P INFLATION Due to a recession, expected inflation this year is only 3.25%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 3.25%. Assume that the expectations theory holds and the real risk-free rate (r) is 2.5%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 1.5%, what inflation rate is expected after Year 1?11P MATURITY RISK PREMIUM An investor in Treasury securities expects inflation to be 2.1% in Year 1, 2.7% in Year 2, and 3.65% each year thereafter. Assume that the real risk-free rate is 1.95% and that this rate will remain constant. Three-year Treasury securities yield 5.20%, while 5-year Treasury securities yield 6.00%. What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is MRP5 MRP3?13P EXPECTATIONS THEORY AND INFLATION Suppose 2-year Treasury bonds yield 4.1%, while 1-year bonds yield 3.2%. r is 1%, and the maturity risk premium is zero. a. Using the expectations theory, what is the yield on a 1-year bond 1 year from now? Calculate the yield using a geometric average. b. What is the expected inflation rate in Year 1? Year 2?EXPECTATIONS THEORY Assume that the real risk-free rate is 2% and that the maturity risk premium is zero. If a 1-ycar Treasury bond yield is 5% and a 2-year Treasury bond yields 7%, what is the 1-year interest rate that is expected for Year 2? Calculate this yield using a geometric average. What inflation rate is expected during Year 2? Comment on why the average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2.16P INTEREST RATE PREMIUMS A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The market expects that inflation will average 2.5% over the next 10 years (IP10 = 2.5%). Assume that there is no maturity risk premium (MRP = 0) and that the annual real risk-free rate, r, will remain constant over the next 10 years. (Hint: Remember that the default risk premium and the liquidity premium are zero for Treasury securities: DRP = LP = 0.) A 5-year corporate bond has the same default risk premium and liquidity premium as the 10-year corporate bond described. What is the yield on this 5-year corporate bond?18P 19P INTEREST RATE DETERMINATION AND YIELD CURVES a. What effect would each of the following events likely have on the level of nominal interest rates? 1. Households dramatically increase their savings rate. 2. Corporations increase their demand for funds following an increase in investment opportunities. 3. The government runs a larger-than-expected budget deficit. 4. There is an increase in expected inflation. b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%; and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0 02(t 1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.3%. You may determine the default risk premium (DRP), given the companys bond rating, from the table below. Remember to subtract the bonds LP from the corporate spread given in the table to arrive at the bonds DRP. What yield would you predict for each of these two investments? Rate Corporate Bond Yield Spread = DRP + LP U.S. Treasury 0.83% ---- AAA corporate 0.93 0.10% AA corporate 1.29 0.46 A corporate 1.67 0.84 c. Given the following Treasury bond yield information, construct a graph of the yield curve. Maturity Yield 1 year 5.37% 2 years 5.47 3 years 5.65 4 years 5.71 5 years 5.64 10 years 5.75 20 years 6.33 30 years 5.94 d. Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. e. Which part of the yield curve (the left side or right side) is likely to be most volatile over time? f. Using the Treasury yield information in part c, calculate the following rates using geometric averages: 1. The 1-year rate 1 year from now 2. The 5-year rate 5 years from now 3. The 10-year rate 10 years from now 4. The 10-year rate 20 years from now INTEREST RATE DETERMINATION Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rates. Your boss has prepared some questions for you to consider. a. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? b. What is the real risk-free rate of interest (r) and the nominal risk-free rate (rRF)? How are these two rates measured? c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included in determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed. d. What is the term structure of interest rates? What is a yield curve? e. Suppose most investors expect the inflation rate to be 5% next year, 6% the following year, and 8% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero for bonds that mature in 1 year or less and 0.1% for 2-year bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-, 10-, and 20-year Treasury bonds? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping? f. At any given time, how would the yield curve facing a AAA-rated company compare with the yield curve for U.S. Treasury securities? At any given time, how would the yield curve facing a BB-rated company compare with the yield curve for U.S. Treasury securities? Draw a graph to illustrate your answer. g. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates? h. Suppose you observe the following term structure for Treasury securities: Maturity Yield 1 year 6.0% 2 years 6.2 3 years 6.4 4 years 6.5 5 years 6.5 Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve provided to back out the markets expectations about future interest rates.) What does the market expect will be the interest rate on 1-year securities 1 year from now? What does the market expect will be the interest rate on 3-year securities 2 years from now? Calculate these yields using geometric averages. i. Describe how macroeconomic factors affect the level of interest rates. How do these factors explain why interest rates have been lower in recent years?A sinking fund can be set up in one of two ways: The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity. The trustee uses the annual payments to retire a portion of the issue each year, calling a given percentage of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is cheaper. What are the advantages and disadvantages of each procedure from the viewpoint of the firm and the bondholders?Can the following equation be used to find the value of a bond with N years to maturity that pays interest once a year? Assume that the bond was issued several years ago. V6=t=1NAnnualinterest(1+rd)t+Parvalue(1+rd)N The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices. Is that statement true or false? Explain. (Hint: Make up a reasonable example based on a 1-year and a 20-year bond to help answer the question.)If interest rates rise after a bond issue, what will happen to the bonds price and YTM? Does the time to maturity affect the extent to which interest rate changes affect the bonds price? (Again, an example might help you answer this question.)Discuss the following statement: A bonds yield to maturity is the bonds promised rate of return, which equals its expected rate of return.6Q Assume that you have a short investment horizon (less than 1 year). You are considering two investments: a 1-year Treasury security and a 20-year Treasury security. Which of the two investments would you view as being riskier? Explain.Indicate whether each of the following actions will increase or decrease a bonds yield to maturity: a. The bonds price increases. b. The bond is downgraded by the rating agencies. c. A change in the bankruptcy code makes it more difficult for bondholders to receive payments in the event the firm declares bankruptcy. d. The economy seems to be shifting from a boom to a recession. Discuss the effects of the firms credit strength in your answer. e. Investors learn that the bonds are subordinated to another debt issue.Why is a call provision advantageous to a bond issuer? When would the issuer be likely to initiate a refunding call?10Q 11Q Why are convertibles and bonds with warrants typically offered with lower coupons than similarly rated straight bonds?13Q 14Q 15Q Which of the following bonds has the most price risk? Explain your answer. (Hint: Refer to Table 7.2.) a. 7-year bonds with a 5% coupon. b. 1-year bonds with a 12% coupon. c. 3-year bonds with a 5% coupon. d. 15-year zero coupon bonds. e. 15-year bonds with a 10% coupon.17Q 1P YIELD TO MATURITY AND FUTURE PRICE A bond has a 1,000 par value, 12 years to maturity, and an 8% annual coupon and sells for 980. a. What is its yield to maturity (YTM)? b. Assume that the yield to maturity remains constant for the next three years. What will the price be 3 years from today?3P YIELD TO MATURITY A firms bonds have a maturity of 8 years with a 1,000 face value, have an 11% semiannual coupon, are callable in 4 years at 1,154, and currently sell at a price of 1,283.09. What are their nominal yield to maturity and their nominal yield to call? What return should investors expect to earn on these bonds?BOND VALUATION An investor has two bonds in his portfolio that have a face value of 1,000 and pay an 11% annual coupon. Bond L matures in 12 years, while Bond S matures in 1 year. a. What will the value of each bond be if the going interest rate is 6%, 8%, and 12%? Assume that only one more interest payment is to be made on Bond S at its maturity and that 12 more payments are to be made on Bond L. b. Why does the longer-term bonds price vary more than the price of the shorter-term bond when interest rates change?BOND VALUATION An investor has two bonds in her portfolio. Bond C and Bond Z. Each bond matures in 4 years, has a face value of 1,000, and has a yield to maturity of 8.2%. Bond C pays an 11.5% annual coupon, while Bond Z is a zero coupon bond. a. Assuming that the yield to maturity of each bond remains at 8.2% over the next 4 years, calculate the price of the bonds at each of the following years to maturity: Years to Maturity Price of Bond C Price of Bond Z 4 __________ __________ 3 __________ __________ 2 __________ __________ 1 __________ __________ 0 __________ __________ b. Plot the time path of prices for each bond.INTEREST RATE SENSITIVITY. An investor purchased the following 5 bonds. Each bond had a par value of 1,000 and an 8% yield to maturity on the purchase day. Immediately after the investor purchased them, interest rates fell, and each then had a new YTM of 7% What is the percentage change in price for each bond after the decline in interest rates? Fill in the following table:8P 9P 10P BOND YIELDS Last year Carson Industries issued a 10-year, 13% semiannual coupon bond at its par value of 1,000. Currently, the bond can be called in 6 years at a price of 1,065 and it sells for 1,200. a. What are the bonds nominal yield to maturity and its nominal yield to call? Would an investor be more likely to earn the YTM or the YTC? b. What is the current yield? Is this yield affected by whether the bond is likely to be called? (Hint: Refer to footnote 7 for the definition of the current yield and to Table 7.1.) c. What is the expected capital gains (or loss) yield for the coming year? Is this yield dependent on whether the bond is expected to be called? Explain your answer.12P PRICE AND YIELD A 7% semiannual coupon bond matures in 4 years. The bond has a face value of 1,000 and a current yield of 7.5401%. What are the bonds price and YTM? (Hint: Refer to footnote 7 for the definition of the current yield and to Table 7.1.)14P BOND VALUATION Bond X is noncallable and has 20 years to maturity, an 8% annual coupon, and a 1,000 par value. Your required return on Bond X is 9%; if you buy it, you plan to hold it for 5 years. You (and the market) have exportations that in 5 years, the yield to maturity on a 15-year bond with similar risk will be 7.5%. How much should you be willing to pay for Bond X today? (Hint You will need to know how much the bond will be worth at the end of 5 years.)16P 17P YIELD TO MATURITY AND YIELD TO CALL Kempton Enterprises has bonds outstanding with a 1,000 face value and 10 years left until maturity. They have an 11% annual coupon payment, and their current price is 1,185. The bonds may be called in 5 years at 109% of face value (Call price = 1,090). a. What is the yield to maturity? b. What is the yield to call if they are called in 5 years? c. Which yield might investors expect to earn on these bonds? Why? d. The bonds indenture indicates that the call provision gives the firm the right to call the bonds at the end of each year beginning in Year 5. In Year 5, the bonds may be called at 109% of face value; but in each of the next 4 years, the call percentage will decline by 1%. Thus, in Year 6, they may be called at 108% of face value; in Year 7, they may be called at 107% of face value; and so forth. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call the bonds?19SP BOND VALUATION Robert Black and Carol Alvarez are vice presidents of Western Money Management and codirectors of the companys pension fund management division A major new client, the California League of Cities, has requested that Western present an investment seminar to the mayors of the represented cities. Black and Alvarez, who will make the presentation, have asked you to help them by answering the following questions. a. What are a bonds key features? b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? c. How is the value of any asset whose value is based on expected future cash flows determined? d. How is a bonds value determined? What is the value of a 10-year, 1,000 par value bond with a 10% annual coupon if its required return is 10%? e. 1. What is the value of a 13% coupon bond that is otherwise identical to the bond described in part d? Would we now have a discount or a premium bond? 2. What is the value of a 7% coupon bond with these characteristics? Would we now have a discount or premium bond? 3. What would happen to the values of the 7%, 10%, and 13% coupon bonds over time if the required return remained at 10%? (Hint: With a financial calculator, enter PMT, l/YR, FV, and N; then change (override) N to see what happens to the PV as it approaches maturity.) f. 1. What is the yield to maturity on a 10-year, 9% annual coupon, 1,000 par value bond that sells for 887.00? That sells for 1,134.20? What does the fact that it sells at a discount or at a premium tell you about the relationship between rd and the coupon rate? 2. What are the total return, the current yield, and the capital gains yield for the discount bond? Assume that it is held to maturity, and the company docs not default on it. (Hint: Refer to footnote 7 for the definition of the current yield and to Table 7.1.) g. What is price risk? Which has more price risk, an annual payment 1-year bond or a 10-year bond? Why? h. What is reinvestment risk? Which has more reinvestment risk, a 1-year bond or a 10-year bond? i. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10% coupon bond if nominal rd = 13%. j. Suppose for 1,000 you could buy a 10%, 10-year, annual payment bond or a 10%, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If 1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond? k. Suppose a 10-year, 10% semiannual coupon bond with a par value of 1,000 is currently selling for 1,135.90, producing a nominal yield to maturity of 8%. However, it can be called after 4 years for 1,050. 1. What is the bonds nominal yield to call (YTC)? 2. If you bought this bond, would you be more likely to cam the YTM or the YTC? Why? l. Does the yield to maturity represent the promised or expected return on the bond? Explain. m. These bonds were rated AA by SP. Would you consider them investment-grade or junk bonds? n. What factors determine a companys bond rating? o. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments? Explain.Suppose you owned a portfolio consisting of 250,000 of long-term U.S. government bonds. a. Would your portfolio be riskless? Explain. b. Now suppose the portfolio consists of 250,000 of 30-day Treasury bills. Every 30 days your bills mature, and you will reinvest the principal (250,000) in a new batch of bills. You plan to live on the investment income from your portfolio, and you want to maintain a constant standard of living. Is the T-bill portfolio truly riskless? Explain. c. What is the least risky security you can think of? Explain.2Q 3Q Is it possible to construct a portfolio of foal-world stocks that has a required return equal to the risk-free rate? Explain.Stock A has an expected return of 7%, a standard deviation of expected returns of 35%, a correlation coefficient with the market of - 0.3, and a beta coefficient of -0.5. Stock B has an expected return of 12%, a standard deviation of returns of 10%, a 0.7 correlation with the market, and a beta coefficient of l.0. Which security is riskier? Why?A stock had a 12% return last year, a year when the overall stock market decline. Does this mean that the stock has a negative beta and thus very little risk if held in a portfolio? Explain.If investors aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stock? Explain.8Q In Chapter 7, we saw that if the market interest rate, rd, for a given bond increased, the price of the bond would decline. Applying this same logic to stocks, explain (a) how a decrease in risk aversion would affect stocks prices and earned rates of return, (b) how this would affect risk premiums as measured by the historical difference between returns on stocks and returns on bonds, and (c) what the implications of this would be for the use of historical risk premiums when applying the SML equation.Suppose you own Stocks A and B. Based on data over the past decade, the Sharpe ratio for Stock A is 13, white the Sharpe ratio for Stock B is 0.8 Briefly explain which stock has performed better.11Q EXPECTED RETURN A stocks returns have the following distribution: Demand For the Companys Products Probability of this D-emand Occurring Rate of Return if this Demand Occurs Weak 0.1 (3%) Below average 0.1 (14) Average 0.3 11 Above average 0.3 20 Strong 0.2 45 1.0 Assume the risk-free rate is 2%. Calculate the stocks expected return, standard deviation, coefficient of variation, and Sharpe ratio.PORTFOLIO BETA An individual has 20,000 invested in a stock with a beta of 0.6 and another 75,000 invested in a stock with a beta of 2.5. If those are the only two investments in her portfolio, what is her portfolios beta?REQUIRED RATE OF RETURN Assume that the risk-free rate is 5.5% and the required return on the market is 12%. What is the required rate of return on a stock with a beta of 2?EXPECTED AND REQUIRED RATES OF RETURN Assume that the risk-free rate is 3.5% and the market risk premium is 4%. What is the required return for the overall stock market? What is the required rate of return on a stock with a beta of 0.8?BETA AND REQUIRED RATE OF RETURN A stock has a required return of 9%, the risk-free rate is 4.5%, and the market risk premium is 3%. a. What is the stocks beta? b. If the market risk premium increased to 5%, what would happen to the stocks required rate of return? Assume that the risk-free rate and the beta remain unchanged.EXPECTED RETURNS Stocks A and B have the following probability distributions of expected future returns: Probability A B 0.1 (10%) (35%) 0.2 2 0 0.4 12 20 0.2 20 25 0.1 38 45 a. Calculate the expected rate of return, rB, foe stock B (rA = 12%). b. Calculate the standard deviation of expected returns, A, for Stock A(B = 20.35%). Now calculate the coefficient of variation for Stock B. Is it possible the most investors will regard Stock B as being less risky than Stock A? Explain. c. Assume the riskfree rate 2.5%. What are the Sharpe ratios for Stocks A and B? Are these calculations consistent with the information obtained from the coefficient of variation calculations in part b? Explain.PORTFOLIO REQUIRED RETURN Suppose you are the money manager of a 4.82 million investment fund. The fund consists of four stocks with the following investments and betas: Stock Investment Beta A 460,0000 1.50 B 500,000 (0.50) C 1,260,000 125 D 2,600,000 0.75 If the markets required rate of return is 8% and the risk-free rate is 4%, what is the funds required rate of return?BETA COEFFICIENT Given the following; information, determine the beta coefficient for Stock L that is consistent with equilibrium: rL = 10-5%; rRF = 3.5%; TM = 9.5%.REQUIRED RATE OF RETURN Stock R has a beta of 2.0, Stock s has a beta of 0.45, the required return on an average stock is 10%, and the risk-free rate of return is 5%. By how much does the required return on the riskier stock exceed the required return on the less risky stock?10P CAPM AND REQUIRED RETURN Calculate the required rate of return for Mudd Enterprises assuming that investors expect a 3.6% rate of inflation in the future. The real risk-free rate is 1.0%, and the market risk premium is 6.0%. Mudd has a beta of l.5, and its realized rate of return has averaged 8.5% over the past 5 years.REQUIRED RATE OF RETURN Suppose rRF = 4%, rM = 10%, and bi = 14. a. What is ri, the required rate of return on Stock i? b. Now suppose that rRF (1) increases to 5% or (2) decreases to 3%. The slope of the SML remains constant. How would this affect rM and ri? c. Now assume that rRF remains at 4%, but rM (1) increases to 12% or (2) falls to 9%. The slope of the SML does not remain constant. How would these changes affect ri?CAPM, PORTFOLIO RISK, AND RETURN Consider the following information for Stocks A, B, and C. The returns on the three stocks are positively correlated, but they are net perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.) Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 53%, and the market is in equilibrium. (That is, required returns equal expected returns.) a. What is the market risk premium (rM rRF)? b. What is the beta of Fund P? c. What is the required return of Fund P? d. Would you expect the standard deviation of Fund P to be less than 15%, equal to 15%, or greater than 15%? Explain.14P 15P CAPM AND PORTFOLIO RETURN You have been managing a 5 million portfolio that has a beta of 1.15 and a required rate of return of 11.475%. The current risk-free rate is 4%. Assume that you receive another 500,000. If you invest the money in a stock with a beta of 0.85, what will be the required return on your 5.5 million portfolio?PORTFOLIO BETA A mutual fund manager has a 20 million portfolio with a beta of 1.7. The risk-free rate is 4.5%, and the market risk premium is 7%. The manager expects to receive an additional 5 million, which she plans to invest in a number of stocks. After investing the additional funds, she wants the funds required return to be 15%. What should be the average beta of the new stocks added to the portfolio?EXPECTED RETURNS Suppose you won the lottery and had two options: (1) receiving 0.5 million or (2) taking a gamble in which, at the flip of a coin, you receive 1 million if a head comes up but receive zero if a tail comes up. a. What is the expected value of the gamble? b. Would you take the sure 0.5 million or the gamble? c. If you chose the sure 0.5 million, would that indicate that you are a risk averter or a risk seeker? d. Suppose the payoff was actually 0.5 million that was the only choice. You now face the choice of investing it in a U.S. Treasury bond that will return 537,500 at the end of a year or a common stock that has a 50-50 chance of being worthless or worth 1,150,000 at the end of the year. l. The expected profit on the T-bond investment is 37,500. What is the expected dollar profit on the stock investment? 2. The expected rate of return on the T-bond investment is 7.5%. What is the expected rate of return on the stock investment? 3. Would you invest in the bond or the stock? Why? 4. Exactly how large would the expected profit (or the expected rate of return) have to be on the stock investment to make you invest in the stock, given the 7.5% return on the bond? 5. How might your decision be affected if, rather than buying one stock for 0.5 million, you could construct a portfolio consisting of 100 stocks with 5,000 invested in each? Each of these stocks has the same return characteristics as the one stock that is, a 50-50 chance of being worth zero or 11,300 at year-end. Would the correlation between returns on these stocks matter? Explain.EVALUATING RISK AND RETURN Stock X has a 10% expected return, a beta coefficient of 0.9, and a 35% standard deviation of expected returns. Stock Y has a 12.5% expected return, a beta coefficient of 1.2, and a 25% standard deviation. The risk-free rate is 6%, and the market risk premium is 5%. a. Calculate each stocks coefficient of variation. b. Which stock is riskier for a diversified investor? c. Calculate each stocks required rate of return. d. On the basis of the two stocks expected and required returns, which stock would be more attractive to a diversified investor? e. Calculate the required return of a portfolio that has 7,500 invested in Stock X and 2,500 invested in Stock Y. f. If the market risk premium increased to 6%, which of the two stocks would have the larger increase in its required return?REALIZED RATES OF RETURN Stocks A and have the following historical returns: a. Calculate the average rate of return for each stock during the period 2014 through 2018. b. Assume that someone held a portfolio consisting of 50% of Stock A and 50% of Stock B. What would the realized rate of return on the portfolio have been each year? What would the average return on the portfolio have been during this period? c. Calculate the standard deviation of returns for each stock and for the portfolio. d. Calculate the coefficient of variation for each stock and for the portfolio. e. Assuming you are a risk-averse investor, would you prefer to hold Stock A, Stock B, or the portfolio? Why?21P 22SP 23IC 1TCL USING PAST INFORMATION TO ESTIMATE REQUIRED RETURNS Use online resources to work on this chapters questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions. Chapter 8 discussed the basic trade-off between risk and return. In the capital asset pricing model (CAPM) discussion, beta was identified as the correct measure of risk for diversified shareholders. Recall that beta measures the extent to which the returns of a given stock move with the stock market. When using the CAPM to estimate required returns, we would like to know how the stock will move with the market in the future, but because we dont have a crystal ball, we generally use historical data to estimate this relationship with beta. As mentioned in Web Appendix 8A, beta can be estimated by regressing the individual stocks returns against the returns of the overall market. As an alternative to running our own regressions, we can rely on reported betas from a variety of sources. These published sources make it easy for us to readily obtain beta estimates for most large publicly traded corporations. However, a word of caution is in order. Beta estimates can often be quite sensitive to the time period in which the data are estimated, the market index used, and the frequency of the data used. Therefore, it is not uncommon to find a wide range of beta estimates among the various Internet websites. On the summary screen, you should see an interactive chart. Typically, you can chart performance over the last 24 hours, 1 month, 6 monthsup to 5 years, or even longer. Select different time periods and watch how the graph changes. On this screen you should also see a menu to select historical prices (historical data). Some websites will not only show daily activity but also weekly or monthly activity In addition, some websites will allow you to download the data into an Excel spreadsheet.4TCL 5TCL 7TCL 8TCL It is frequently stated that the one purpose of the preemptive right is to allow individuals to maintain their proportionate share of the ownership and control of a corporation. a. How important do you suppose control is for the average stockholder of a firm whose shares are traded on the New York Stock Exchange? b. Is the control issue likely to be of more importance to stockholders of publicly owned or closely held (private) firms? Explain.Is the following equation correct for finding the value of a constant growth stock? Explain. P0=Dors+g 3Q Two investors are evaluating GEs stock for possible purchase. They agree on the expected value of D1 and on the expected future dividend growth rate. Further, they agree on the riskiness of the stock. However, one investor normally holds stocks for 2 years, while the other holds stocks for 10 years. On the basis of the type of analysis done in this chapter, should they both be willing to pay the same price for GEs stock? Explain.A bond that pays interest forever and has no maturity is a perpetual bond. In what respect is a perpetual bond similar to a no-growth common stock? Are there preferred stocks that are evaluated similarly to perpetual bonds and other preferred issues that are more like bonds with finite lives? Explain.Discuss the similarities and differences between the discounted dividend and corporate valuation models.7Q How do non-operating assets impact a firms valuation using the corporate valuation model?DPS CALCULATION Weston Corporation just paid a dividend of 1.00 a share (i.e., D0 = 1.00). The dividend is expected to grow 12% a year for the next 3 years and then at 5% a year thereafter. What is the expected dividend per share for each of the next 5 years?CONSTANT GROWTH VALUATION Tresnan Brothers is expected to pay a 1.80 per share dividend at the end of the year (i.e., D1 = 1.80). The dividend is expected to grow at a constant rate of 4% a year. The required rate of return on the stock, rs, is 10%. What is the stocks current value per share?CONSTANT GROWTH VALUATION Holtzman Clothierss stock currently sells for 38.00 a share. It just paid a dividend of 2.00 a share (i.e., D0 = 2.00). The dividend is expected to grow at a constant rate of 5% a year. What stock price is expected 1 year from now? What is the required rate of return?NONCONSTANT GROWTH VALUATION Holt Enterprises recently paid a dividend, D0, of 2.75. It expects to have nonconstant growth of 18% for 2 years followed by a constant rate of 6% thereafter. The firms required return is 12%. a. How far away is the horizon date? b. What is the firms horizon, or continuing, value? c. What is the firms intrinsic value today, P0?CORPORATE VALUATION Scampini Technologies is expected to generate 25 million in free cash flow next year, and FCF is expected to grow at a constant rate of 4% per year indefinitely. Scampini has no debt or preferred stock, and its WACC is 10%. If Scampini has 40 million shares of stock outstanding, what is the stocks value per share?PREFERRED STOCK VALUATION Farley Inc. has perpetual preferred stock outstanding that sells for 30 a share and pays a dividend of 2.75 at the end of each year. What is the required rate of return?7P PREFERRED STOCK VALUATION Earley Corporation issued perpetual preferred stock with an 8% annual dividend. The stock currently yields 7%, and its par value is 100. a. What is the stocks value? b. Suppose interest rates rise and pull the preferred stocks yield up to 9%. What is its new market value?PREFERRED STOCK RETURNS Avondale Aeronautics has perpetual preferred stock outstanding with a par value of 100. The stock pays a quarterly dividend of 1.00 and its current price is 45. a. What is its nominal annual rate of return? b. What is its effective annual rate of return?10P Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or a short-term basis? Why?12P CONSTANT GROWTH You are considering an investment in Justus Corporations stock, which is expected to pay a dividend of 2.25 a share at the end of the year (D1 = 2.25) and has a beta of 0.9. The risk-free rate is 4.9%, and the market risk premium is 5%. Justus currently sells for 46.00 a share, and its dividend is expected to grow at some constant rate, g. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? (That is, what is P3?)NONCONSTANT GROWTH Computech Corporation is expanding rapidly and currently needs to retain all of its earnings; hence, it does not pay dividends. However, investors expect Computech to begin paying dividends, beginning with a dividend of 0.50 coming 3 years from today. The dividend should grow rapidlyat a rate of 35% per yearduring Years 4 and 5; but after Year 5, growth should be a constant 7% per year. If the required return on Computech is 13%, what is the value of the stock today?15P NONCONSTANT GROWTH Carnes Cosmetics Co.s stock price is 30, and it recently paid a 1.00 dividend. This dividend is expected to grow by 30% for the next 3 years, then grow forever at a constant rate, g; and rs = 9%. At what constant rate is the stock expected to grow after Year 3?CONSTANT GROWTH Your broker offers to sell you some shares of Bahnsen Co. common stock that paid a dividend of 2.00 yesterday. Bahnsens dividend is expected to grow at 5% per year for the next 3 years. If you buy the stock, you plan to hold it for 3 years and then sell it. The appropriate discount rate is 12%. a. Find the expected dividend for each of the next 3 years; that is, calculate D1, D2, and D3. Note that D0 = 2.00. b. Given that the first dividend payment will occur 1 year from now, find the present value of the dividend stream; that is, calculate the PVs of D1, D2, and D3, and then sum these PVs. c. You expect the price of the stock 3 years from now to be 34.73; that is, you expect P3 to equal 34.73. Discounted at a 12% rate, what is the present value of this expected future stock price? In other words, calculate the PV of 34.73. d. If you plan to buy the stock, hold it for 3 years, and then sell it for 34.73, what is the most you should pay for it today? e. Use Equation 9.2 to calculate the present value of this stock. Assume that g = 5% and that it is constant. f. Is the value of this stock dependent upon how long you plan to hold it? In other words, if your planned holding period was 2 years or 5 years rather than 3 years, would this affect the value of the stock today, P0? Explain.NONCONSTANT GROWTH STOCK VALUATION Taussig Technologies Corporation (TTC) has been growing at a rate of 20% per year in recent years. This same growth rate is expected to last for another 2 years, then decline to gn =6%. a. If D0 = 1.60 and rs = 10%, what is TICs stock worth today? What are its expected dividend, and capital gains yields at this time, that is, during Year 1? b. Now assume that ITCs period of supernormal growth is to last for 5 years rather than 2 years. Flow would this affect the price, dividend yield, and capital gains yield? Answer in words only. c. What will TTCs dividend and capital gains yields be once its period of supernormal growth ends? (Hint: These values will be the same regardless of whether you examine the case of 2 or 5 years of supernormal growth; the calculations are very easy.) d. Explain why investors are interested in the changing relationship between dividend and capital gains yields over time.19P CORPORATE VALUE MODEL Assume that today is December 31,2019, and that the following information applies to Abner Airlines: After-tax operating income [EBIT (1 T)] for 2020 is expected to be 400 million. The depreciation expense for 2020 is expected to be 140 million. The capital expenditures for 2020 are expected to be 225 million. No change is expected in net operating working capital. The free cash flow is expected to grow at a constant rate of 6% per year. The required return on equity is 14%. The WACC is 10%. The firm has 200 million of non-operating assets. The market value of the companys debt is 3.875 billion. 200 million shares of stock are outstanding. Using the corporate valuation model approach, what should be the companys stock price today?NONCONSTANT GROWTH Assume that it is now January 1, 2017. Wayne-Martin Electric Inc. (WME) has developed a solar panel capable of generating 200% more electricity than any other solar panel currently on the market. As a result, WME is expected to experience a 15% annual growth rate for the next 5 years. Other firms will have developed comparable technology by the end of 5 years, and WMEs growth rate will slow to 5% per year indefinitely. Stockholders require a return of 12% on WMEs stock. The most recent annual dividend which was paid yesterday, was 1.75 per share. a. Calculate WMEs expected dividends for 2017, 2018, 2019, 2020, and 2021. b. Calculate the value of the stock today, P0. Proceed by finding the present value of the dividends expected at the end of 2017, 2018, 2019, 2020, and 2021 plus the present value of the stock price that should exist at the end of 2021. The year end 2021 stock price can be found by using the constant growth equation. Notice that to find the December 31, 2021, price, you must use the dividend expected in 2022, which is 5% greater than the 2021 dividend. c. Calculate the expected dividend yield (D1/P0), capital gains yield, and total return (dividend yield plus capital gains yield) expected for 2017. (Assume that P0=P0 and recognize that the capital gains yield is equal to the total return minus the dividend yield.) Then calculate these same three yields for 2022. d. How might an investors tax situation affect his or her decision to purchase stocks of companies in the early stages of their lives, when they are growing rapidly, versus stocks of older, more mature firms? When does WMEs stock become mature for purposes of this question? e. Suppose your boss tells you she believes that WMEs annual growth rate will be only 12% during the next 5 years and that the firms long-run growth rate will be only 4%. Without doing any calculations, what general effect would these growth rate changes have on the price of WMEs stock? f. Suppose your boss also tells you that she regards WME as being quite risky and that she believes the required rate of return should be 14%, not 12%. Without doing any calculations, determine how the higher required rate of return would affect the price of the stock, the capital gains yield, and the dividend yield. Again, assume that the long-run growth rate is 4%.Comprehensive/Spreadsheet Problem NONCONSTANT GROWTH AND CORPORATE VALUATION Rework problem 9-18, parts a, b, and c, using a spreadsheet model. For part b, calculate the price, dividend yield, and capital gains yield as called for In the problem. After completing parts a through c, answer the following additional question, using the spreadsheet model. d. TTC recently introduced a new line of products that has been wildly successful. On the basis of this success and anticipated future success, the following free cash flows were projected: After the tenth year, TTCs financial planners anticipate that its free cash flow will grow at a constant rate of 6%. Also, the firm concluded that the new product caused the WACC to fall to 9%. The market value of TTCs debt is 1,200 million; it uses no preferred stock; and there are 20 million shares of common stock outstanding. Use the corporate valuation model to value the stock. 9-18 NONCONSTANT GROWTH STOCK VALUATION Taussig Technologies Corporation (TTC) has been growing at a rate of 20% per year in recent years. This same growth rate is expected to last for another 2 years, then decline to gn =6%. a. If D0 = 1.60 and rs = 10%, what is TICs stock worth today? What are its expected dividend, and capital gains yields at this time, that is, during Year 1? b. Now assume that ITCs period of supernormal growth is to last for 5 years rather than 2 years. Flow would this affect the price, dividend yield, and capital gains yield? Answer in words only. c. What will TTCs dividend and capital gains yields be once its period of supernormal growth ends? (Hint: These values will be the same regardless of whether you examine the case of 2 or 5 years of supernormal growth; the calculations are very easy.) d. Explain why investors are interested in the changing relationship between dividend and capital gains yields over time.23IC 1TCL 2TCL 3TCL 4TCL 5TCL 6TCL 7TCL 8TCL 9TCL For a stock to be in equilibrium, what two conditions must hold?2Q RATES OF RETURN AND EQUILIBRIUM Stock Cs beta coefficient is bC = 0.4, and Stock Ds is bD = 0.5. (Stock Ds beta is negative, indicating that its return rises when returns on most other stocks fall. There are very few negative beta stocks, although collection agency stocks are sometimes cited as an example.) a. If the risk-free rate is 7% and the required rate of return on an average stock is 11%, what are the required rates of return on Stocks C and D? b. For Stock C, suppose the current price, P0, is 25.00; the next expected dividend, D1 is 1.50; and the stocks expected constant growth rate is 4%. Is the stock in equilibrium? Explain and describe what will happen if the stock is not in equilibrium.

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