Golden Apples

Professor Jerry Langham

MBA 554: 262
27 January 2009
Chapter 5: Problems 1, 2, 3, 4, 7, 12, & 25
1. Bond Yields. A 30-year Treasury bond is issued with face value of $1,000, paying
interest of $60 per year. If market yields increase shortly after the T-bond is issued,
what happens to the bonds
a. coupon rate? The fixed rate is 6% and will not change the $60 per year.
b. price? Price is dependent upon the market interest rate. If the market interest
rate goes up, the bond price goes down; if the interest rate goes down, the
price of the bond must increase.
c. yield to maturity? If the market yield increases, the yield to maturity will
increase, and vice versa.
d. current yield? Current rate = coupon rate bond price. As the bond price
changes the current yield will as well. If the bond price is lower, the current
yield will be higher and vice versa.
2. Bond Yields. If a bond with face value of $1,000 and a coupon rate of 8 percent is
selling at a price of $970, is the bonds yield to maturity more or less than 8 percent?
What about the current yield?
Because the bond is discounted, the yield to maturity must be more than 8%, so
the yield to maturity is greater than the coupon rate.
Current yield = coupon payment bond price
Coupon payment = $1000 * .08 = $80
CY = 80 970 = 8.247 which is greater than 8%.
3. Bond Yields. A bond with face value $1,000 has a current yield of 7 percent and a
coupon rate of 8 percent. What is the bonds price?
If x = the bond price
.07 = 80/x

x= 80/.07 = $1,142.86
4. Bond Pricing. A 6-year Circular File bond pays interest of $80 annually and sells for
$950. What are its coupon rate, current yield, and yield to maturity?
Coupon rate = 80/1000 = 8%
Current yield = 80 950 = 8.42%
Yield to maturity =
950 = 80 * ((1/r)- (1/(r*(1+r)^6)))+ (1000/(1+r)^6)
In calcN = 6, PV = -950, PMT = 80, FV = 1000
= 9.119%
7.Coupon Rate. General Matters outstanding bond issue has a coupon rate of 10
percent and a current yield of 9.6 percent, and it sells at a yield to maturity of 9.25
percent. The firm wishes to issue additional bonds to the public at face value. What
coupon rate must the new bonds offer in order to sell at face value?
The yield to maturity = coupon rate, so the new bond needs to be 9.25 to sell
at face value.
12. Bond Pricing. A 30-year maturity bond with face value of $1,000 makes annual
coupon payments and has a coupon rate of 8 percent. What is the bonds yield to
maturity if the bond is selling for
1. $900? N=30, FV=1000, PMT = 80, PV = -900 I/YR = 8.9708%
2. $1,000? N=30, FV=1000, PMT = 80, PV = -1000 I/YR = 8%
3. $1,100? N=30, FV=1000, PMT = 80, PV = -11000 I/YR = 7.1796%
25. Real Returns. Suppose that you buy a 1-year maturity bond for $1,000 that will
pay you back $1,000 plus a coupon payment of $60 at the end of the year. What real
rate of return will you earn if the inflation rate is
1. 2 percent? (1.06/1.02) 1 = 0.039215686 = 3.92%
2. 4 percent? (1.06/1.04) 1 = 0.019230769 = 1.92%
3. 6 percent? (1.06/1.06) 1 = 1%
4. 8 percent? (1.06/1.08) 1 = -0.018518519 = -1.85%

Chapter 6: Problems 1, 2, 3, 4, 13, 17, 19 and 32

1. Dividend Discount Model. Amazon.com has never paid a dividend, but in June 2005
the market value of its stock was $13 billion. Does this invalidate the dividend
discount model?
No.
2. Dividend Yield. Favored stock will pay a dividend this year of $2.40 per share. Its
dividend yield is 8 percent. At what price is the stock selling?
Dividend yield = Dividend Price
8% = 2.4/p
p=2.4/.08 = 30
The price of the stock is $30.
3.Preferred Stock. Preferred Products has issued preferred stock with an $8 annual
dividend that will be paid in perpetuity.
If the discount rate is 12 percent, at what price should the preferred sell?
Price = Dividend rate
P = $8/.12
P = $66.67
At what price should the stock sell 1 year from now?
Part A has already solved for the first dividend so the price will be $66.67.
What is the dividend yield, the capital gains yield, and the expected rate of
return of the stock?
Dividend yield = Dividend Price
DY = 8/66.67 = .12 = 12%
Capital gains yield
rate= (dividend price) + growth rate

.12 = 8/66.67 + g
.12 = .12 + g
g=0
Therefore the capital yield gain is 0.

Expected Rate of Return

r = 8/66.67 + 0 = .12 = 12%
4. Constant-Growth Model. Waterworks has a dividend yield of 8 percent. If its
dividend is expected to grow at a constant rate of 5 percent, what must be the
expected rate of return on the companys stock?
Rate = (dividend price) + growth rate
r = .08 + .05 = .12 = 12%

13. Constant-Growth Model. Gentleman Gym just paid its annual dividend of $3 per
share, and it is widely expected that the dividend will increase by 5 percent per year
indefinitely.
What price should the stock sell at? The discount rate is 15 percent.
Price = Dividend (rate growth rate)
P = 3 * 1.05 /(.15 - .05) = $31.50
Note: Multiply the dividend by 1.05 because the growth rate of .05 applies to
the Div1 for the current years growth.
How would your answer change if the discount rate were only 12 percent? Why
does the answer change?
P = 3 * 1.05 /(.12 - .05) = $45
The less that the discount rate is, the less the denominator becomes which
cause the dividend to increase.
17.Negative Growth. Horse and Buggy Inc. is in a declining industry. Sales, earnings,

and dividends are all shrinking at a rate of 10 percent per year.

If r = 15 percent and DIV1 = $3, what is the value of a share?
Price = DIV1 (rate growth rate)
P0 = 3/ (.15 (-.10))
P0 = 3/ (.15 + .10)
P0 = 3/.25 = $12
What price do you forecast for the stock next year?
P1 = DIV1 * (1 + Growth rate)/(rate growth rate)
P1 = 3(1+ (-.10))/(.15 (-.10))
P1 = 2.7/.25 = $10.80
What is the expected rate of return on the stock?
(Dividend + capital gain) Price
(3 + (10.80-12)) 12
1.8/12 = .15 = 15%
Can you distinguish between bad stocks and bad companies? Does the fact
that the industry is declining mean that the stock is a bad buy?
Even if the stock price is falling, the expected rate of return may still be
acceptable.
19. Nonconstant Growth. You expect a share of stock to pay dividends of $1.00,
$1.25, and $1.50 in each of the next 3 years. You believe the stock will sell for $20 at
the end of the third year.
What is the stock price if the discount rate for the stock is 10 percent?
Price = (DIV1/(1+r)) + (DIV2/((1+r)^2))) + (DIV3/ ((1+r)^3))) + (PV3/((1+r)^3)))
Price = 1/(1+.10) + (1.25/ ((1+.1)^2))) + (1.5/ ((1+.1)^3))) + (20/ ((1+.1)^3)))
Price = (1/1.1) + (1.25/1.21) + (1.5/1.331) + (20/1.331)

P = 18.095 = $18.10
What is the dividend yield?
DIV/Price = 1/18.10 = .05524 = 5.5%
32. Interpreting the Efficient-Market Theory. How would you respond to the following
comments?
Efficient market, my eye! I know lots of investors who do crazy things.
Although what investors do may appear to be crazy, in fact, the steps taken
must reflect all available information in order for the investment to be worth
while.
Efficient market? Balderdash! I know at least a dozen people who have made a
bundle in the stock market.
Okay, but how many have lost a bundle especially in our current market?
The trouble with the efficient-market theory is that it ignores investors
psychology.
The concept of investor psychology is not a solid concept to describe investor
behavior. In fact, the term may be interpreted in a variety of ways. Anyone
that attempts to use this approach to investing is taking substantial risk.