Financial Management (BUSI 640) Professor Mathews

Problem Set #2

1. Suppose that US Treasury bonds with different maturities (spaced every 6 months)
currently have the following yields:

Maturity 6 months 12 months 18 months 24 months

Zero-CouponYield 1.2% 1.32% 1.45% 1.5%

a. What should be the current price of a two-year, $10,000 Treasury bond paying
semi-annual coupons at a stated annual coupon rate of 2%?

b. What is the Yield-to-Maturity on this coupon bond, stated on a bond-equivalent

basis (i.e., expressed as an APR assuming semi-annual compounding)?

c. Now suppose that the 24-month zero-coupon bond yield increases (while the
other zero-coupon yields stay the same), and correspondingly the YTM on the
two-year coupon bonds rises by 25 basis points relative to what you calculated in
part b (for example, if you previously calculated it as 1.75%, it would now be
2.00%). What must the new 24-month zero-coupon bond yield be?

2. Assume that a stock will begin paying dividends one year from today, starting with a
fifty cent annual dividend. The consensus analyst forecast is that dividends will grow
at 12% per year for the following four years (meaning that the dividend in year 5 is
expected to be 12% higher than the dividend in year 4). After that, it is believed that
the dividend growth rate will fall to a long-term perpetual 5% rate.

a. Estimate the value of the stock if the market requires a 14% expected return.

b. Estimate the value of the stock if the market requires a 9% expected return.
3. A motor manufacturer (ticker RPM) currently pays out 40% of their annual net
income, retaining the rest for further investments in new opportunities. The estimated
return on equity (ROE) of these new projects is 12%.

a. Estimate the dividend growth rate, assuming that the payout ratio and expected
returns on investment stay constant.

b. Next years expected dividend is $0.66 per share. If the market requires a 15%
expected return on the firms equity, what is your estimate of the current stock
price of RPM?

c. If the firm decided to cut its investment and instead pay out 100% of annual
earnings in dividends, what do you expect would be the new price of RPM stock?

d. Why would the market respond positively to this announcement, i.e. why did the
stock price increase? Hint: If you did not find that the stock price in part c is
higher than the price found in part b, you may want to re-check your numbers.