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Application: Investing in the Stock Market

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I started investing in stock 2 years ago and I have always wondered how bonds work, but never took the time to research on them. I have seen how many local governments use bond to raise money for their municipality, but I have always seen that many people lose money. Bonds are used to borrow money from the public on a long term basis and during that time the borrower will pay the interest. Something that I found interesting is that when interest rates rise, the present value of the bond's remaining cash flows declines, and the bond is worth less. When interest rates fall, the bond is worth more. Stocks and bonds are a little different because in a common stock not even the promised cash flows are known in advance, stock has no maturity and there is no way to easily observe the rate of return the market requires.

I started investing in the stock market thinking what many people still think that you just put your money on a stock and it will grow and I would be millionaire, but the truth is that is not that easy. Many companies as we know issue stocks to increase their cash, but when a company's issues dividends is to recompense the investors for investing that money in them. A company usually issue dividends only when there is enough money left over after all operating and expansion expenses are met. Companies usually attempt to maintain balance their debt and equity ratios before making any dividends distribution (Investopedia, 2015).

Reference:
Investopedia (2015) Dividends Retrived from: http://www.investopedia.com/articles/03/011703.asp on 5 Jan 2015

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Most of your comments about stocks and bonds are correct. Bottom line is that both comes with their fair share of risks and return. Bonds offer periodic interest payments (generally every 6 months or every year) and at the end of the ...

Solution Summary

This solution responds to a stock investment scenario.

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Bond and Stock Valuation Basis and Applications

Question 5
a. The Lutfus Corp offers a 6% bond with a current market price of $875.05. The yield to maturity is
7.34%. The face value is $1,000. Interest is paid semiannually. How many years is it until this bond
matures?
b. A corporate bond with a face value of $1,000 matures in 4 years and has a 8% coupon paid at the end
of each year. The current price of the bond is $932. What is the yield to maturity for this bond?
c. The Chocolate Factory Inc. is expecting its ice cream sales to decline due to the increased interest in
healthy eating. Thus, the company has announced that it will be reducing its annual dividend by 5% a
year for the next two years. After that, it will maintain a constant dividend of $1 a share. Two weeks
ago, the company paid a dividend of $1.40 per share. What is the current worth of the stock if you
require a 9% rate of return?
d. Active Planet Bhd. is preparing to pay its first dividends. It is going to pay $1.00, $2.50, and $5.00 a
share over the next three years, respectively. After that, the company has stated that the annual
dividend will be $1.25 per share indefinitely. What is the current worth of this share if you require a
7% rate of return?
e. Your portfolio consists of $100,000 invested in a stock which has a beta = 0.8, $150,000 invested in a
stock which has a beta = 1.2, and $50,000 invested in a stock which has a beta = 1.8. The risk-free rate
is 7 percent. Last year this portfolio had a required rate of return of 13 percent. This year nothing has
changed except for the fact that the market risk premium has increased by 2 percent (two percentage
points). What is the portfolio's current required rate of return?

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