Chapter 8: Valuation and Rates of Return 183

CHAPTER 8: VALUATION AND RATES OF RETURN

Text Problem Solutions

1. a. At a constant growth rate of 10%, you would recommend a maximum price for purchase of $13.20.

b. With a 3-year 20% growth rate followed immediately by a constant 10% growth, you would recommend a
price of $16.61.

c. If the growth gradually changes from 20% to 10%, the highest price you would recommend is $19.80.

Exhibit 8 - 1
184 Chapter 8: Valuation and Rates of Return
Exhibit 8 - 2
Chapter 8: Valuation and Rates of Return 185
2. The answers to questions a. Value, b. Yield to Maturity, and c. Yield to call are in column B. Answers to d.
Value, Yield to Maturity and Yield to Call are in column E.

e. Since the bond is selling at a discount (interest rates have risen) the bond is unlikely to be called.

Exhibit 8 - 3
186 Chapter 8: Valuation and Rates of Return
Exhibit 8 - 4
Chapter 8: Valuation and Rates of Return 187
Internet Exercise 1. This data is from 1 November 2002. The calculated intrinsic value is $7.94 less than the actual
market price of the stock. If the required return is actually 10% per year, then the stock is currently overvalued and
should not be purchased.

Exhibit 8 - 5
188 Chapter 8: Valuation and Rates of Return
Exhibit 8 - 6
Chapter 8: Valuation and Rates of Return 189
Internet Exercise 2. The bond chosen for this solution was the Ralston Purina Company 7.875's of 2025. The dated
date is 15 June 1995, and the first coupon was paid on 15 December 1995. The prices and yields are as of 3
November 2002.

Note: After the book went to press, a service called TRACE was greatly expanded and made available by the NASD
and the Bond Market Association. This service provides 4-hour delayed trade reporting on all corporate bonds rated
A- or higher and with an issue size greater than $100 million. It will eventually report on all corporate bond trades
that take place in the OTC market. Historical data is also available for the previous 90 days.

The data are available at two sites:

http://www.investinginbonds.com/
http://www.nasdbondinfo.com/

At this time, the NASD site seems much better as it provides a search tool and detailed information on the issue.

Exhibit 8 - 7
190 Chapter 8: Valuation and Rates of Return
Exhibit 8 - 8
Chapter 8: Valuation and Rates of Return 191

Instructor’s Manual Problem Set

1. The market portfolio has an expected return of 10% and the risk-free rate is 4%. Based on the security market
line implied by this information, which of the following securities are correctly priced and which are
over/underpriced?

Exhibit 8 - 9

2. Calculate the intrinsic value of the following shares of common stock. Assume a constant growth rate in
dividends as specified.

Exhibit 8 - 10

3. A 20-year bond is purchased on 9/15/97 with a coupon rate of 6%, interest paid semi-annually. The current
required return is 8%. Using both the present value and price functions, what is the intrinsic value, current yield
and yield to maturity of this bond? If the bond is selling for $940 in the market, what is the market's current
yield and yield to maturity?

4. Calculate the unknown values for preferred stock indicated in the table below.

Exhibit 8 - 11
192 Chapter 8: Valuation and Rates of Return
5. What is the intrinsic value of a common stock that last paid a dividend of $0.30 under the following conditions if
your required rate of return is 10%?

a. There is no expected growth in dividends.

b. Dividends are expected to grow at a constant rate of 6% per year indefinitely.

c. Dividends are expected to grow at a rate of 12% for four years and then immediately drop to a constant
growth rate of 6% indefinitely.

d. Dividends are expected to grow at a rate of 12% for four years and then gradually drop over three years to a
constant growth rate of 6% indefinitely.

Internet Exercise

6. Select a company of your choice and obtain the dividend payment history for the last five years from the Yahoo!
Finance Web site as described in the Internet Exercise in the text for this chapter. Calculate the growth rate in
dividends on a quarterly basis and then annualize the rate. Calculate the intrinsic value of the company’s stock
to you (using your required rate of return). Compare this to the latest price for the company’s common stock.
Would you purchase this company’s stock?
Chapter 8: Valuation and Rates of Return 193

Instructor’s Manual Problem Set Solutions

1. Data points X, Y and Z have been added to the risk-free rate and market portfolio to produce a graph that can be
used to visually solve this problem. Solutions can obviously be reached mathematically as well.

Exhibit 8 - 12

Exhibit 8 - 13
194 Chapter 8: Valuation and Rates of Return
Exhibit 8 - 14

2. Solutions to the common stock valuations are:

Exhibit 8 - 15

Exhibit 8 - 16
Chapter 8: Valuation and Rates of Return 195
3. Bond computations and answers are shown below. The intrinsic value of the bond using present value and price
functions are slightly different due to the extra five days used in the present value function. Adding five (5) to
the maturity date (B5) will result in identical values for present value and price.

Exhibit 8 - 17

Exhibit 8 - 18
196 Chapter 8: Valuation and Rates of Return
4. Preferred stock valuation computations are:

Exhibit 8 - 19

Exhibit 8 - 20
Chapter 8: Valuation and Rates of Return 197
5. Answers to questions a-d are displayed in Column D below:

Exhibit 8 - 21
198 Chapter 8: Valuation and Rates of Return
Exhibit 8 - 22
Chapter 8: Valuation and Rates of Return 199
Internet Exercise

6. Harley-Davidson was selected to demonstrate this exercise.

Exhibit 8 - 23
200 Chapter 8: Valuation and Rates of Return
Exhibit 8 - 24