FIN 300 – Homework Assignment #2

Due by 11.59pm on February 14

This homework assignment is to be submitted electronically via Canvas. If you feel that a
question misses essential information, make a reasonable assumption and clearly state that
assumption.
No late homework will be accepted. You are allowed to – and I encourage you to – work
together on homework assignments. However, you must hand in your own individual
homework. Photocopies (or any other form of copies such as pictures taken of someone
else’s homework) are unacceptable. You must show how you obtained all your answers.
Homework assignments are graded pass (1) / fail (0): to pass, you have to attempt 100% of the
homework assignment.

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Chapter 8 & 9 Problems

#1. Consider a pure-discount bond that matures in exactly 12 years and pays $1,000 at maturity
(with annual compounding).
(a) What is the value of the bond if the discount rate is 6%?
(b) What is the value of the bond if the discount rate is 12%?
(c) Assuming the bond is priced at the value you calculated in (b), what is the bond’s yield-to-
maturity?

#2. Consider a level-coupon bond with the following parameters:

Principal (i.e., face value) $1,000

Time to maturity 10 years
Coupon rate 8% annually (i.e., 4% every 6-months)
Payments semiannually
Appropriate semi-annual discount rate 5%
(this is the correct discount rate for cash flows delivered 6 months from today)

What is the value of the bond?

#3. A firm just paid its $1 annual dividend. The dividend is expected to grow at a 12% annual
rate for the next 4 years (i.e., 4 periods of growth at 12%) and then growth will slow down to 5%
(i.e., growth at 5% for all subsequent periods). Given the riskiness of the firm’s profits, the
appropriate discount rate for the firm’s dividend stream is 10%. What should the current price
for the stock be?

#4. A firm’s earnings this past year were $40 million. The firm’s return on equity remains on its
historical trend of 12 percent, and the firm maintains a policy of retaining 50 percent of its
earnings. What is the firm’s growth rate of earnings? What will next year’s earnings be?

#5. XYZ Corp has just reported earnings of $20 million and has paid its annual dividend. The
firm retains 75 percent of its earnings and expects to continue to do so. The company has 1.25
million shares of common stock outstanding. The stock is selling for $60 and the company’s
ROE is 12% and is expected to stay at that level in the future.

What is the discount rate on the stock?

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#6. Special Info Inc. just reported earnings of $1.5 million. The firm will retain 40 percent of its
earnings. The historical return on equity is 15 percent, and this figure is expected to continue
into the future. The firm has 300,000 shares outstanding. The appropriate discount rate on the
stock is 13 percent.

(a) What is the firm’s growth rate of earnings?

(b) What is the price of the stock?
(c) The firm has an opportunity to invest in a new project. The project requires an additional
investment of $1.2 million today and it will generate additional cash flows in the next 10
years. The first additional cash flows of $0.3 million will begin one year from now and
grow at a 10 percent each year thereafter. Calculate the NPV of the new project.
(d) What will the stock price be if the firm undertakes the new project?

#7. Ross Stores, Inc., has experienced a steady growth of 8% per year in its annual dividend.
This growth is expected to continue indefinitely. The last dividend paid was $1.10 per share
(D0 = 1.10). Investors require a 14% return on their investment.

a. What is the current price of Ross?

b. What will the price be in 4 years?

c. What is the current dividend yield?

d. What is the capital gains yield?

#8 You get a phone call from one of your high school friends who is now working for a
computer software company, Netscam, that is developing a program that he claims will
revolutionize Internet surfing. Since he is such a trusted friend, you decide to immediately call
your broker and have her buy 100 shares of Netscam stock for you right away. Your broker
executes the transaction at $48 per share and faxes you some information about the company.
Apparently, you just missed Netscam’s last dividend. However, analysts predict dividends of
$2.00 next year, and they expect the dividends to grow at 15% annually for the following two
years. After that, the dividends are expected to level-off to a growth rate of 5% annually. For
this somewhat risky investment, you require a 12% return.

(a) What is the fair value of the stock today?

(b) Did you pay too much for the stock, or was it a bargain?

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#9 According to the Small Street Journal, Generals Motor has a bond maturing in 19 years that
has a 9.5% coupon. The bond is selling for $862.00. The face value of the bond is 1,000.

(a) What is the Yield to Maturity on this bond if it pays semi-annual interest?

(b) Five years have passed and the bond is now selling for $930 (the bond matures in 14
years). What is the Yield to Maturity now? Explain what has happened.

Chapter 7 Problems

#10. A firm is considering producing and selling a new product. The initial investment is $9.9
million. If the product is a success, one year after the initial investment the product will generate
an annual cash flow of $2,000,000 in perpetuity with the first cash flow arriving one year after
the investment. If the product is not a success, the initial investment will generate an annual cash
flow of $0 in perpetuity. Managers only learn if the product is a success if they make this $9.9
million initial investment. The initial investment has no salvage value.

The probability that the product is a success is 50%. However, by spending one year test-
marketing the product before making the investment, the firm believes they can raise the
probability of success to 75%. The test marketing will cost $4,000,000. To be clear, if the firm
conducts the test marketing at date 0 and spends $4,000,000, then at date 1 they can decide to
invest in the project after the test marketing is complete. In this event, if they choose to invest at
date 1, they anticipate that there will now be a 75% chance of success, in which case the project
will generate an annual cash flow of $2,000,000 each year starting at date 2. If the project is not
a success, it will never generate any cash flow.

(a) The discount rate is 10%. Should the firm conduct the test marketing?

(b) What is the break-even cost for the test-marketing?

The break-even cost is the cost of the marketing test such that you're indifferent
between testing and not testing: NPV (testing) = NPV (not testing).

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Chapter 10 Problems

#11. You purchased 1,000 shares of stock at a price of $74 per share one year ago. Your
dividend payment from these shares has been $4,000. The stock is now selling for a price of $76
per share.
(a) What is your capital gain?
(b) What is your total dollar return?
(c) What is your total percentage return?

#12. The total percentage returns on large company stocks were as follows:

1994: 1.27%
1995: 37.80%
1996: 22.74%
1997: 33.43%
1998: 28.13%

What was an investor’s 5-year holding period return for large company’s stocks over this period?

#13. A portfolio has exhibited the following returns over the past 7-years.

Year –7 -1.30%
Year –6 -0.50%
Year –5 21.9%
Year –4 2.35%
Year –3 8.20%
Year –2 15.05%
Year –1 9.95%

(a) What was the mean (i.e., average) return over this period?
(b) What was the variance and standard deviation of returns over this period?