1. Suppose Floyd Motor Company sold an issue of bonds on January 1, 2001. The bonds were sold for $1,000 per unit (i.e., they were issued at par), had a 10 percent coupon rate payable semi-annually, and matures in 15 years, i.e., on December 31, 2015.
a) If you bought the bond on the issue date at the issue price and expected to hold it until it matures on December 31, 2015, what would be your average annual rate of return on the investment?
b) Two years after the bonds were issued the going rate of interest on similar bonds fell to 8 percent. At what price would the bonds sell?
c) Six years after the initial offering, the going interest rate on similar bonds rose to 12 percent. At what price would the bonds sell?
d) Eight years after the issue, the bonds were selling for $925. What is the bond's yield to maturity at this point? What is the current yield? What is the capital gains yield?
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The solution computes fair value of bond issued under different circumstances and scenarios in the attached Excel file.
Bond Valuation, Stock Valuation, Preferred Stock Required Return, Preferred Stock Valuation, Bond Valuation/ YTM/ Interest Rate Risk, Bond Returns, Stock/ Business Valuation, CAPM
Capital Structure Decisions & Credit Ratings
Dividend Adjustment Model
Bond Funding: Public/Private Placement
Net Advantage to Leasing
A1. A $ 1,000 face value bond has a remaining maturity of 10 years and a required return of 9%. The bond's coupon rate is 7.4%. What is the fair value of this bond?
A 10. (Dividend Discount model) Assume RHM is expected to pay a total cash dividend of $5.60 next year and its dividends are expected to grow at a rate of 6% per year forever. Assuming annual dividend payments, what is the current market value of a share of RHM stock if the required return on RHM common stock is 10%?
A12. (Required return for preferred stock) James River $3.38 preferred is selling for $45.25. The preferred dividend is nongrowing. What is the required return on James River preferred stock?
A 14. (Stock valuation) Suppose Toyota has nonmaturing (perpetual) preferred stock outstanding that pays a $1.00 quarterly dividend and has a required return of 12% APR. What is the stock worth?
B 16. (Interest rate risk) Philadelphia Electric has many bonds trading on the New York Stock Exchange. Suppose PhilEl's bonds have identical coupon rates of 9.125% but that one issue matures in 1 year, one in 7 years, and the third in 15 years. Assume that a coupon payment was made yesterday
a. If the yield to maturity for all three bonds is 8%, what is the fair price of each bond?
b. Suppose that the yield to maturity for all of these bonds changed instantaneously to 7%. What is the fair price of each bond now?
c. Suppose that the yield to maturity for all of these bonds changed instantaneously again, this time to 9%. Now what is the fair price of each bond?
d. Based on the fair prices at the various yields to maturity, is interest-rate risk the same, higher, or lower for longer-versus shorter-maturity bonds?
B 18. (Default risk) You buy a very risky bond that promises a 9.5% coupon and return of $1,000 principal in 10 years. You pay only $500 for the bond.
a) You receive the coupon payments for three years and the bond defaults. After liquidating the firm, the bondholders receive a distribution of $150 per bond at the end of 3.5 years. What is the realized return on your investment?
b) The firm does far better than expected and bondholders receive all of the promised interest and principal payments. What is the realized return on your investment?
B 20. (Constant growth model) Medtrans is a profitable firm that is not paying a dividend on its common stock. James Weber, an analyst for A.G. Edwards, believes that Medtrans will begin paying a $1.00 per share dividend in two years and that the dividend will increase 6% annually thereafter. Bret Kimes, one of James' colleagues at the same firm, is less optimistic. Bret thinks that Medtrans will begin paying a dividend in four years, that the dividend will be $1.00, and that it will grow at 4% annually. James and Bret agree that the required return for Medtrans is 13%.
a. What value would James estimate for this firm?
b. What value would Bret assign to the Medtrans stock?
C1. (Beta and required return) The riskless return is currently 6%, and Chicago Gear has estimated the contingent returns given here.
a. Calculate the expected returns on the stock market and on Chicago Gear stock.
b. What is Chicago Gear's beta?
c. What is Chicago Gear's required return according to the CAPM?
State of the market Probability that state occurs Stock market Chicago Gear
Stagnant 0.20 -10.00% -15.00%
Slow growth 0.35 10.00% 15.00%
Average growth 0.30 15.00% 25.00%
Rapid growth 0.15 25.00% 35.00%
B1. (Choosing financial targets) Bixton Company's new chief financial officer is evaluating Bixton's capital structure. She is concerned that the firm might be underleveraged, even though the firm has larger-than-average research and development and foreign tax credits when compared to other firms in its industry. Her staff prepared the industry comparison shown here.
a. Bixton's objective is to achieve a credit standing that falls, in the words of the chief financial officer, "comfortably within the 'A' range." What target range would you recommend for each of the three credit measures?
b. Before settling on these target ranges, what other factors should Bixton's chief financial officer consider?
c. Before deciding whether the target ranges are really appropriate for Bixton in its current financial situation, what key issues specific to Bixton must the chief financial officer resolve?
Rating Category Fixed Charge Coverage Funds From Operations/Total Debt Long-Term Debt/Capitalization
Aa 4.00-5.25x 60-80% 17-23%
A 3.00-4.30 45-65 22-32
Baa 1.95-3.40 35-55 30-41
A10. (Dividend adjustment model) Regional Software has made a bundle selling spreadsheet software and has begun paying cash dividends. the firm's chief financial officer would like the firm to distribute 25% of its annual earnings (POR = 0.25) and adjust the dividend rate to changes in earnings per share at the rate ADJ = 0.75. Regional paid $1.00 per share in dividends last year. It will earn at least $8.00 per share this year and each year in the foreseeable future. Use the dividend adjustment model, Equation (18.1), to calculate projected dividends per share for this year and the next four.
B2. (Dividend policy) A firm has 20 million common shares outstanding. It currently pays out $1.50 per share year in cash dividends on its common stock. Historically, its payout ratio has ranged from 30% to 35%. Over the next five years it expects the earnings and discretionary cash flow shown below in millions.
A.over the five year period, what is the maxium overall payout ratio the firm could acieve without triggering a securities issue?
B. Recommend a reasonable dividend policy for paying out discretionary cash flow in years 1 through 5.
1 2 3 4 5 Thereafter
Earnings 100 125 150 120 140 150+ per year
Discrecreary cash flow 50 70 60 20 15 50+per year
A2. (Comparing borrowing costs) Stephens Security has two financing alternatives: (1) A publicly placed $50 million bond issue. Issuance costs are $1 million, the bond has a 9% coupon paid semiannually and the bond has a 20-year life. (2) A $50 million private placement with a large pension fund. Issuance costs are $500,000, the bond has a 9.25% annual coupon, and the bond has a 20-year life. Which alternative has the lower cost (annual percentage yield)?
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