principal-of-finance-topic2-tute

PrinciplesofFinanceTopic2UniversityofAdelaide©2005Page1QuestionsQuestion1SupposeHomesafeCabCoisconsideringanexpansionwhichitwillfinancethroughadditionaldebenturesales.CurrentoutstandingHomesafedebenturesaresellingfor$75.25.Thesehaveafacevalueof$100,acouponof8%and15yearstomaturity.Ifinterestispaidsemi-annually,whatmusttheyieldofthenewdebenturesbeinorderfortheissuetosellatpar?a.8.9%b.13.32%c.5.2%d.11.5%Question2SupposeGrowthUnlimitedhasjustpaida$1dividend.Overthenext3years,youestimatethedividendswillincrease50%,25%and20%respectively.Afterthat,dividendsshouldgrowat10%peryear.Anappropriatediscountrateforthisfirmis15%.ThestockpriceforGrowthUnlimitedis:a.$36.75b.$33.98c.$56.55d.$12.73Question3CBCsharesaresellingfor$10.Supernormalgrowthof20%isexpectedforthenext2years.Thecurrentdividendis$0.5andtherequiredreturnis15%.Whatconstantgrowthrateisexpectedbeginninginyear3?a.6.6%b.7.2%c.7.8%d.8.4%Question4GogetumCorp.haspreferredstockthatpaysa$14dividend.Thestocksellsfor$225.Ifthecompanywishestoissuenewpreferred,theunderwriting,orfloatation,costsareapproximately2%.WhatisGogetum’scostofpreferredstock?a.6.22%b.6.4%c.6.35%d.$14timesnumberofpreferredsharesoutstanding.PrinciplesofFinanceTopic2UniversityofAdelaide©2005Page2Question5Youhavejustpurchasedanewlyissued$1,000five-yearTroshaniCompanybondatpar.Thisfive-yearbondpays$60ininterestsemi-annually.YouarealsoconsideringthepurchaseofanotherTroshaniCompanybondthatpays$30insemi-annualinterestpaymentsandhassixyearsremainingbeforematurity.Thisbondhasafacevalueof$1,000.(a)Whatistheyieldonthefive-yearbond(expressedasaneffectiveannualyield)?Themarketinterestrateandthecouponrateareequalbecausethebondissellingatpar.Sincethefacevalueofthebondis$1,000andthesemi-annualcouponpaymentis$60,thesemi-annualcouponrateis6percent(=$60/$1,000).Thus,thesemi-annualinterestisalsosixpercent.Calculatetheyield,expressedasaneffectiveannualyield,bycompoundingthesemi-annualinterestrateovertwoperiods.Yield=112r=106.12=0.1236Theyieldis0.1236.(b)Assumethatthefive-yearbondandthesix-yearbondhavethesameyield.Whatshouldyoubewillingtopayforthesix-yearbond?YouarewillingtopayapriceequaltothePVofthebond’spayments.TofindthePVofthe12couponpayments,applytheannuityformula,discountedatthesemi-annualrateofreturn.Also,discountthe$1,000paymentmadeatmaturitybacktothepresent.Thediscountrate,r,isthesameascalculatedinpart(a).P=NiTtrFVrC111=1211206.1000,106.130it=$748.49Thepriceofthebondis$748.49.(c)Howwillyouranswertopart(b)changeifthefive-yearbondpays$40insemi-annualinterestinsteadof$60?Assumethatthefive-yearbondpaying$40ispurchasedatpair.Ifthefive-yearbondpays$40insemi-annualpaymentsandispricedatpar,thesemi-annualrateofreturnwillbedifferentfromthatinpart(a).SincethePrinciplesofFinanceTopic2UniversityofAdelaide©2005Page3facevalueofthebondis$1,000andthesemi-annualcouponpaymentis$40,thesemi-annualinterestrateisfourpercent(=$40/$1,000).Tocalculatethepriceofthebond,applytheannuityformula,discountedatthesemi-annualinterestrate.Inaddition,discountthe$1,000paymentmadeatmaturityback12periods.P=NiTtrFVrC111=1211204.1000,104.130it=$906.15Thepriceofthebondis$906.15.Question6Ageneralizedmodelforthevalueofanyassetisthepresentvalueoftheexpectedcashflows:NittkCFValue11whereN=lifeoftheasset,tCF=cashflowinperiodtandk=appropriatediscountrate.Bothstockandbondvaluationmodelsuseadiscountedcashflowapproach,whichincludestheestimationofthreefactors(kCFNt,,).Explainwhyeachofthesethreefactorsisgenerallymoredifficulttoestimateforcommonstocksthanfortraditionalcorporatebonds.[CFALevelIIExamQuestion](a)Lifeoftheasset(N).Typically,bondshaveastatedmaturity.Bondinvestorswillbepaidcouponsandrepaidprincipalatorbeforethatmaturity.Thelifeofthebondiscontractuallydeterminedandcreatesanobligationtohonorthepromisedpayments.Thereisnomaturityforcommonstocksbecausethelifeofthecorporationiscommonlyassumedtobeinfinite.(b)Cashflow(tCF).Thecontractualnatureofbondpaymentscreatesanobligation,whichmakestheestimationofthesepaymentsafairlyroutinetask,especiallyforhighqualitybonds.Dividendpaymentsoncommonstocks,ontheotherhand,aremuchmoredifficulttoestimatebecausedividendsarediscretionaryorPrinciplesofFinanceTopic2UniversityofAdelaide©2005Page4indeterminatebasedonfactorssuchasprofitability,financialstructure,capitalexpenditures,ormanagementdiscretion.(c)AppropriateDiscountRate(k).Thediscountrate,orrequiredrateofreturn,reflectstheriskoftheasset.Therequiredrateofreturnonabondisobservableandtypicallydeterminedbycomparisonwithotherbondsofsimilarmaturity(asindicatedbytheyieldcurve)andissuercreditrisk(asindicatedbythebondrating).Theestimationoftherequiredrateofreturnforacommonstockismoresubjective,oftenrelyingonanestimatedriskproxysuchasbetaorsimilarmeasuresofriskiness.Question7GiGiLimitedhasanissueofpreferredstockoutstandingthatpaysa$7dividendeveryyear,inperpetuity.Ifthisissuecurrentlysellsfor$90.21pershare,whatistherequiredreturn?Thepriceashareofpreferredstockisthedividenddividedbytherequiredreturn.Thisisthesameequationastheconstantgrowthmodel,