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Valuation, Interest rates, Constant growth, Preferred stock value

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Questions:

(5-2) "Short-term interest rates are more volatile than long-term interest rates, so short-term bond prices are more sensitive to interest rate changes than are long-term bond prices." Is this statement true or false? Explain.

(5-3) The rate of return you would get if you bought a bond and held it to its maturity date is called the bond's yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond's price and to its YTM? Does the length of time to maturity affect the extent to which a giving change in interest rates will affect the bond's price?

(5-5) A sinking fund can be set up in one of two ways. Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders.

Problems:

(5-1)
Bond Valuation with
Annual Payments
Jackson Corporation's bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds?

(5-4)
Determinant of
Interest Rates
The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-years Treasure securities? What is the yield on 3-years Treasure securities?

Questions:
(1) Discuss the value of foreign (non-United States) stocks in an investment portfolio. Do you want them? If so, which ones? Do you diversify the classes as you would domestic stock? If so, what classes would you select? Any countries you'd avoid? What about a stock index for foreign stocks...is this a good or bad idea?

(7-2) Two investors are evaluating General Electric's stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the risk of the stock. However, one investor normally holds stocks for 2 years and the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for General Electric's stock. True or false? Explain.

(7-3) A bond that pays interest forever and has no maturity date is a perpetual bond, also called a perpetuity or a consol. In what respect is a perpetual bond similar to (1) a no-growth common stock and (2) a share of preferred stock?

(7-4) People have argued that a stock's market price can deviate from its intrinsic value. Discuss the following question: If all investors attempt to behave in an entirely rational manner, could these differences still exist? In answering this question, think about information that's available to insiders versus outsiders, the fact that historical probabilities of financial events are "fuzzier" than probabilities related to physical items, and the validity of the concepts of animal spirits, herding, and anchoring.
Problems:
(7-2)
Constant Growth
Valuation
Boehm Incorporated is expected to pay a $1.50 per share dividend at the end of this year (i.e., D1 = $1.50). The dividend is expected to grow at a constant rate of 7% a year. The required rate of return on the stock, rs, is 15%. What is the value per share of Boehm's stock?

(7-4)
Preferred Stock
Valuation
Nick's Enchiladas Incorporated has preferred stock outstanding that pays a dividend of $5 at the end of each year. The preferred sells for $50 a share. What is the stock's required rate of return?

(7-6)
Constant Growth
Rate, g
A stock is trading at $80 per share. The stock is expected to have a year-end dividend of $4 per share (D1 = $4), and it is expected to grow at some constant rate g through-out time. The stock's required rate of return is 14%. If markets are efficient, what is your forecast of g?

Questions:

(1) From the reading you discovered that most firms rely on a mix of debt, preferred stock, and common equity. Since debt tends to be less risky to bondholders than equity is to stockholders, the cost of debt to the firm (r(d)) is lower than the cost of equity (r(s)). That said, since debt is less expensive than equity, briefly explain why firms tend not to rely upon all (100%) debt to fund their capital needs.

(9-2) How can the WACC be both an average cost and a marginal cost?

(9-3) How would each of the factors in the following table affect a firm's cost of debt, rd (1 - T); its cost of equity, rs; and its weighted average cost of capital, WACC? Indicate by a plus (+), a minus (-), or a zero (0) if the factor would raise, lower, or have an indeterminate effect on the item in question. Assume that all other factors are held constant. Justify your answer, but recognized that several of the parts probably have no single correct answer.

EFFECT ON:
rd (1 - T) rs WACC
a. The corporate tax rate is lowered.
b. The Federal Reserved tightens credit.
c. The firm uses more debt.
d. The firm doubles the amount of capital
it raises during the year.
e. The firm expands into a risky new area.
f. investors become more risk averse.

(9-4) Distinguish between beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a potential project. Of the three measures, which is theoretically the most relevant, and why?

(9-5) Suppose a firm estimates its overall cost of capital for the coming year to be 10 %. What might be reasonable cost of capital for average-risk, high risk, and low-risk projects?

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Solution Summary

Bond valuation, interest rate, constant growths and preferred stock values are examined.

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Questions:

(5-2) "Short-term interest rates are more volatile than long-term interest rates, so short-term bond prices are more sensitive to interest rate changes than are long-term bond prices." Is this statement true or false? Explain.

False. As the time to maturity for the bonds increase, their sensitivity to interest rate changes increase. Hence short term bond prices are less sensitive to the interest rate changes as compared to the long term bond prices. We get back the money invested in short term bonds earlier and can reinvest it at the new interest rates. In case of long term bonds we are locked with the bond interest rate for a much longer period.

(5-3) The rate of return you would get if you bought a bond and held it to its maturity date is called the bond's yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond's price and to its YTM? Does the length of time to maturity affect the extent to which a giving change in interest rates will affect the bond's price?

For investors who bought these bonds prior to the interest rate increase and plan to hold them till maturity, there will be no change in YTM.
The YTM will change only for investors who buy these bonds after the interest rate change.
If interest rate goes up - YTM will go up but the bond price will go down
If the length of time to maturity is high - the bond price will see more decrease

(5-5) A sinking fund can be set up in one of two ways. Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders.
The firm will select the lease cost method.

First way of setting up a sinking fund:
Redeem a certain percentage of the bonds each year at par value:
Advantages to firm:
? If interest rates have fallen, the firm will redeem the bonds and issue new bonds at the new lower interest rates. This will result in reducing its cost of debt
Advantages to shareholders
? Bond with a sinking fund are safer as compared to one with no sinking fund provision.
Disadvantages to firm
? If interest rates have risen, the firm will have to redeem a minimum portion of bonds and issue new bonds at the new higher interest rates. This will result in increasing its cost of debt
Disadvantages to shareholders
? Bonds with sinking fund provision will usually have lower coupon rate as compared to the one without sinking fund provision

Second way of setting up a sinking fund:
Buy the required number of bonds on the open market:
Advantages to firm:
? Since firm is buying the bonds from the open market, firm will be able to maintain its cost of funds.
Advantages to shareholders
? Bond holder are not worried about that firm will call its bonds at par when the bond prices are higher than at par value
? Bond holders are secured that the firm is able to retire the bonds in an orderly fashion.
Disadvantages to firm
? A sinking fund can constituent a significant cash drain on the firm.
Disadvantages to shareholders
? Bonds with sinking fund provision will usually have lower coupon rate as compared to the one without sinking fund provision

Problems:

(5-1)
Bond Valuation with
Annual Payments
Jackson Corporation's bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds?
Value of bond = ...

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