Valuation of Bonds and Stocks (Practice Problems) 1. You are considering the purchase of an issue of Danville Corporations bonds.

When originally issued, the bonds had a face value of $1,000, carried an 8% coupon rate of interest, and matured in fifteen years. Interest is paid semi-annually. Five years have now passed since the issuance of the bonds. BB-rated bonds of similar maturities now carry an interest rate of 12%. How much should you be willing to pay for the bonds? 2. Determine the yield-to-maturity for the bonds in problem #1, assuming that the current market value is $750.00 per bond. In addition to the bonds described above, you are considering the purchase of Danvilles common stock. Danvilles common stock has a beta of 0.75. Assume that the current yield on 6-month Treasury bills is 6%. Your brokerage firm believes that the return on the overall market for the next three years should average 14% per year. You believe that the earnings of the company (which were $8.00 per share last year) and the dividends will both grow at the rate of 8% per year over the next three years. After that, the growth rate of the firm is expected to be 6% per year. You believe that the price/earnings ratio will be 10.6 times earnings at the end of the next three years. The firm pays out 60% of its earnings in the form of dividends. a. b. Determine the required rate of return for Danville, using the capital asset pricing model. Determine the fair market price for Danvilles common stock using a two-stage dividend discount model. This method takes the present value of the dividends and the present value of the selling price of the stock. The future stock price is determined using the Gordon model. Assume a three year holding period. Determine the fair market price for Danvilles stock by using a two-stage dividend discount model and using the price-earnings ratio to predict the future price of the stock. If the current market price of Danvilles stock is $81.00, should you be interested in buying the stock? Why or why not?

3.

c.

d.

Bond Valuation Problem #1 Fair Value of a Bond

Since the interest is paid semi-annually, we must adjust the numbers for semi-annual time periods. The coupon and market rates of interest must be cut in half and the number of time periods must be doubled. The bond will pay $40 in interest (i.e., 4% semi-annually * $1,000) for 20 semi-annual time periods. Assuming a market rate of interest of 12% per year or 6% semi-annually, the fair value of the bond is equal to the present value of the bonds cash flows (using the market rate of 6% semi-annually as the discount rate). The number of semi-annual time periods is 20.

Cash Flow $40.00 1,000.00 Fair Value =

x x x

PVF @6% 11.470 0.312

= = =

Present Value 458.80 312.00 $770.80

Bond Valuation Problem #2 Yield-To-Maturity of a Bond From the previous problem, we know that a buyer can pay $770.80 for the bond and earn a 12% annual rate of return (i.e. 6% semi-annually). If the buyer pays less than $770.80, such as $750.00, the buyer should be able to earn more than 12% annually. Lets repeat the fair value calculations, this time using a higher number for the discount rate. Lets use 14%, which would be 7% semi-annually, to see if the buyer will earn 7% semi-annually. Using 7% as the discount rate, we get a present value of the cash flows of $681.76 (the calculations are not shown here). If we pay more than this price, we will earn less than 7% semi-annually. So we know that if we pay $750.00, we will earn more than 6% but less than 7% semi-annually. We can interpolate to find the actual rate earned, i.e. the yield to maturity. Interpolation 6% difference on top is X outside difference is 1% I.R.R. 750.00 $770.80 difference on top is $20.80 outside difference is $89.04

7%

681.76

Interpolating to find the value of X, we set up a simple proportion:

X 20.80

1.0% 89.04 X = 0.23% YTM = 6.0% + 0.23% = 6.23% semi - an nually (or 12.5% annually)

Valuation Problem #3 Valuation of Common Stock a. Determine the required rate of return, using the capital asset pricing model.
Required Rate of Return = R f + Beta (Returnmarket - R f ) = 6.0% + 0.75 (14.0% - 6.0%) = 12.0%

b.

Determine the fair market price for the stock using a two-stage dividend discount model (with the Gordon model used to determine the future price of the stock).

Year 0 1 2 3 3

Dividends $4.80 5.18 5.60 6.05

Price

* * * *

PVF 0.893 0.797 0.712 0.712 Fair Price

= = = = = =

Present Value $4.63 4.46 4.31 76.10 $89.50

106.88

where the future price in year 3 (of $106.88) is equal to:

Price3 = = Dividend4 k-g

($6.05 * 1.06) 0.12 - 0.06 = $106.88

c.

Determine the fair price by using a two-stage dividend discount model that uses the price/earnings ratio to determine the future price of the stock. Year 0 1 2 3 3 Dividends $4.80 5.18 5.60 6.05 106.82 + Price * * * * PVF 0.893 0.797 0.712 0.712 Fair Price = = = = = = Present Value $4.63 4.46 4.31 76.06 $89.46

where the future price in year 3 (of $106.82) is equal to: Price3 = = = (P/E) 3 10.60 $106.82 x x E3 $10.08

d.

Would you be willing to buy the stock for a price of $81.00? Yes, you would pay $81.00 for a stock which you believe is worth over $89.00 per share.