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Intermediate Finance Questions

1. Why do you think a corporation that is considering investing in a long-term project that will not generate any positive cash flow for several years would fund it by issuing zero-coupon bonds?

2. Which would you expect to have higher interest rates: debentures or mortgage-backed bonds? Please justify your response.

3. What is the difference between a "call" and a "put?" Which party in a bond transaction would prefer the "call" and which the "put?"

4. Would you classify the relationship between bond ratings and the required return on the bond issue as direct or inverse? Why?

5. The price (pv) of a bond is determined by the relationship of the bond's current yield-to- maturity (market rate of interest) to the bond's coupon rate. Please explain under what circumstances the bond will trade (1) at par, (2) at a discount and (3) at a premium in the market.

6. Why is preferred stock referred to as a "hybrid?" Compare and contrast its specific features to bonds and common stock.

7. How is the Dividend Discount Model of valuing equities similar to the method we learned to value bonds?

Calculation Problems (please show your work for possible partial credit):
1. We learned that the current market price of a bond is the total of the present values of (1) the principal/face/par value (future value) of the bond and (2) the income stream of interest payments (annuity). For a $1,000 par bond maturing in 10 years with a coupon rate of 5% making annual interest payments and a market yield (ytm) of 5%, calculate the PV's of (1) and (2) above. (Hint: combined, they will total the par or future value of the bond of $1,000 since ytm = coupon rate). Show your calculations. (10 pts.)

2. What would you be willing to pay (pv) for a 20-year bond that has a maturity value of $1,000 and makes semi-annual interest payments of $40, if you require a 10% annual yield? (5 pts.)

3. What would be the price of a bond that pays $37.50 interest every 3 months that will mature in 15 years with a $1,000 face amount when you require an annual rate of return of 12%? (5 pts.)

4. A share of preferred stock pays an annual dividend of $6 per share. If investors require a 12% return, what is the price of this preferred stock? (5 pts.)

5. The most recent dividend on Spirex Corp's common stock was $4.00 and the expected growth rate is 10%. If the required rate of return is 20%, what is the highest price you should be willing to pay for this stock? (5 pts.)

6. Suppose you are willing to pay $30 today for a share of stock which you expect to sell at the end of the year for $32. If you require an annual rate of return of 12%, what must be the amount of the annual dividend you expect to receive for the year? (5 pts.)

Solution Preview

1. Why do you think a corporation that is considering investing in a long-term project that will not generate any positive cash flow for several years would fund it by issuing zero-coupon bonds?

A zero-coupon bond is a bond that does not pay any coupon until its expiration. This means that what the investor essentially gets is the price paid for the bond at the initial period.

This approach will benefit the company since its projects are not generating any positive cash flows and represent a drain on the resources of the firm. The firm will expectedly utilize the funds gained from the bond to commence the project. it therefore makes sense that the firm will only incur a loss of income in one part instead of from losing money on the project and also experiencing interest payments on the bond.

2. Which would you expect to have higher interest rates: debentures or mortgage-backed bonds? Please justify your response.

The risk, on a financial instrument, is solely determined by the amount of security tied into each. A debenture has no adequate security as collateral while the bond has some sort of security. The security means that the investor would have something to sell to regain his/her initial investment. It therefore implies that the debentures would have higher interest.

3. What is the difference between a "call" and a "put?" Which party in a bond transaction would prefer the "call" and which the "put?"

A call is a contracted price at which an investor can decide to purchase a financial instrument. A ...

Solution Summary

Why corporation that is considering investing in a long-term project that will not generate any positive cash flow for several years is analyzed. The expected higher interest rates are determined.

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