1. A General Motors bond (face value of $1,000) carries a coupon rate of 8 percent, has 9 years until maturity, and sells at a yield to maturity of 9 percent.
a. What interest payments do bondholders receive each year?
b. At what price does the bond sell? (Assume annual interest payments.)
c. What will happen to the bond price if the yield to maturity falls to 7%?
2. You believe that the Goodyear Bulb Company will pay a dividend of $2 on its common stock next year. Thereafter, you expect dividends to grow at a rate of 6 percent a year in perpetuity. If you require a return of 12 percent on your investment, how much should you be prepared to pay for the stock?
3. Micro-Encapsulator Corp. expects to sell 7,200 miniature home encapsulators this year. The cost of placing an order from its supplier is $250. Each unit costs $50 and carrying cost are 20 percent of the purchase price.
a. What is the economic order quantity?
b. What are total costs-order costs plus carrying costs-of inventory over the course of the year?
4. You are considering a new project to bring the manufacture of boxes in-house. The project will require purchasing equipment with total costs of $3 million. The equipment will last for 10 years; its scrap value at that time will be zero. Depreciation is straight-line over 10 years. Bringing the box manufacturing process in-house will save $300,000 per year in box costs. The corporate tax rate is 35%. The appropriate discount rate is 12%.
a. Calculate the NPV of this project. Should you accept the project?
b. What is the present value of the cost savings of the machine?
c. What is the present value of the depreciation tax shield?
5. Mr. Goodie holds American put options on Delta Triangle stock. The exercise price of the put is $40 and Delta stock is selling for $35 per share. If the put sells for $4.5, what is the best strategy for Mr. Goodie?
Here are your answers.
a. We're told that the bond has a coupon rate of 8%. The interest rate paments are based on this rate and the face value of the bond. Since the face value is $1,000, the payments are 8% of $1,000, that is, $80.
b. The price of a bond is the present value of its stream of payments, discounted at the yield to maturity (YTM) rate. Assuming the first interest payment will happen one year from now, the price of this bond is:
Price = 80/1.09 + 80/1.09^2 + 80/1.09^3 + ... + 80/1.09^9 + 1000/1.09^9
[the last term comes from the fact that in the last year, the bond will pay its face value in addition to the coupon]
The result of this formula (which can be calculated "manually" or with a financial calculator) is $940, so that's the fair price of the bond.
c. If the YTM falls to 7%, we have to calculate again, but discounting at the 7% rate:
Price = 80/1.07 + 80/1.07^2 + 80/1.07^3 + ... + 80/1.07^9 + 1000/1.07^9
The result is $1,065.20 (rounded). As you can see, there is an inverse relationship between the YTM and the bond ...
Answers explained clearly.