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1 ASSIGNMENT #2 The purpose of this assignment is to solidify your understanding on the applications of the risk and return concepts and their role in valuing financial assets. The scores of this assignment will help in assessing the following learning goal of the course: “students successfully completing this course will be able to Analyze risk return characteristics to assess valuation of financial assets”. Instructions: You are required to use a financial calculator or spreadsheet (Excel) to solve 10 problems (provided on page 3) related to the risk and return, stocks and bonds valuation. You are required to show the following 3 steps for each problem (sample questions and solutions are provided for guidance): (i) Describe and interpret the assumptions related to the problem. (ii) Apply the appropriate mathematical model to solve the problem. (iii) Calculate the correct solution to the problem. Sample Questions and Solutions Sample Question # 1: A company has an issue of 12-year bonds that pay 5% interest, annually. Further assume that today's required rate of return on these bonds is 7%. How much would these bonds sell for today? Round off to the nearest $1. Solution (i) The problem assumes that the face value of the bond is $1000. The bond will pay an annual coupon of 5% i.e., coupon or interest amount of $50 is assumed to paid every year. It also assumes that investors currently required a return of 7% on investments with similar risk characteristics. The use of bond valuation concept is appropriate to calculate the true value of these bonds. The accuracy of the solution depends on the correctness of the assumptions on face value, coupon payments and required rate of return assumption. (ii) The use of bond valuation concept which suggests that the true value of a bond is the present value of its future coupon and face value discounted at investors required rate of return is appropriate to calculate the true value of these bonds. We are required to compute the present value (PV) which represents the true value of the bond. (iii) FV= $1000; PMT=$50; Rate = 7%; N=12 years; Compute PV = ? $841.15 Value of the Bond = $841.15 2 Sample Question # 2: A company just paid a dividend of $1, and the dividends are expected to grow at constant rate of 4% forever. If the required return of the stockholders is 12%, what is the price of this company’s stock? Solution (i) The problem assumes the stock will have a constant growth of 4% forever. The constant growth model is appropriate to use for this problem. The accuracy of the solution depends on the correctness of the constant growth assumption. (ii) The constant growth model is given as: P0 = D1/ (R-g); where P0 is the current price to be calculated, D1 is the next period’s dividend, R is the required return on this stock g is the constant growth D1 needs to be calculated in order to apply this model. (iii) D1= 1x(1+0.04) = 1.04 P0 = 1.04 /(0.12-0.04) = $13; the stock price should be $13 based on the constant growth model. 3 Assignment Problems 1. Han Corporation issues a bond which has a coupon rate of 9.40%, a yield to maturity of 7.75%, a face value of $1,000, and a market price of $990. What is the semiannual interest payment? Round to two decimal places. 2. A shipping company sold an issue of 14-year $1,000 par bonds to build new ships. The bonds pay 10% interest, compounded semiannually. Today's required rate of return is 8.50%. How much should these bonds sell for today? Round to two decimal places. 3. Assume a company has an issue of 30-year $1,000 par value bonds that pay 4.75% interest, compounded annually. Further assume that today's required rate of return on these bonds is 3.25%. How much would these bonds sell for today? Round to two decimal places. 4. Atlantis Company issued bonds on January 1, 2006. The bonds had a coupon rate of 6.0%, with interest paid semiannually. The face value of the bonds is $1,000 and the bonds mature on January 1, 2024. What is the yield to maturity for these bonds on January 1, 2019 if the market price of the bond on that date is $1,150? Submit your answer as a percentage and round to two decimal places. 5. A $1,000 par value 8-year bond with a 13 percent coupon rate recently sold for $980. What is the yield to maturity if the bond makes semiannual payments? Submit your answer as a percentage rounded to two decimal places. 6. Consider a 7 year bond with face value $1,000 that pays an 8.4% coupon semi-annually and has a yield-to-maturity of 6.9%. What is the approximate percentage change in the price of bond if interest rates in the economy are expected to increase by 0.40% per year? Submit your answer as a percentage and round to two decimal places. (Hint: What is the expected price of the bond before and after the change in interest rates?) 7. Nippon, Inc. expects its current annual $3.30 per share common stock dividend to remain the same for the foreseeable future. What is the intrinsic value of the stock to an investor with a required return of 9.2%? Round to two decimal places. 8. Hackworth Company's common stock is expected to pay a $6.10 dividend in the coming year. If investors require an 11% return and the growth rate in dividends is expected to be 7%, what should the market price of the stock be? Round to two decimal places. 9. Nell Corporation stock is currently selling for $15.50. The stock is expected to pay a dividend of $1.75 at the end of the year. Dividends are expected to grow at a constant rate of 6% indefinitely. Compute the expected rate of return on Nell Corporation stock. Submit your answer as a percentage and round to two decimal places. 10. Finkle-McGraw Corp. just paid a dividend today of $2.60 per share. The dividend is expected to grow at a constant rate of 4.6% per year. If Finkle-McGraw Corp. stock is selling for $72.00 per share, what is the stockholders' expected rate of return? Submit your answer as a percentage and round to two decimal places. Grading Rubric Learning Objective Subcomponent Not Submitted 0 Does Not Meet Expectations 1 Meets expectations 2 Exceeds Expectations 3 The student will make No attempt made Attempts to describe Explicitly describes Explicitly describes assumptions and evaluate important assumptions assumptions and provides rationale for why assumptions in each assumption is appropriate. identification of Show awareness that confidence appropriate asset in final conclusions is limited by valuation variables and the accuracy of the risk and return measures assumptions (e.g., provides descriptions about the assumptions of the model and its limitations; lists and describes each variable within the model) The student will convert No attempt made Completes conversion Completes Relevant information is relevant information into of information but conversion of expressed in an insightful LO#2: Analyze risk return characteristics to assess valuation of financial assets. various mathematical forms (e.g., equations, graphs, words) resulting mathematical portrayal is inappropriate or inaccurate information into mathematical portrayal mathematical portrayal in a way that contributes to a further or deeper understanding (e.g., correct variables are selected and the mathematical model is portrayed with the correct variables) The student will calculate No attempt made Calculations are Calculations are Calculations attempted are risk and return measures attempted but are both attempted to solve essentially all successful and and asset values unsuccessful and not the problem but not sufficiently comprehensive to comprehensive comprehensive solve the problem. Calculations are also presented elegantly (e.g., provides insights on the interpretation of the calculated value of an asset such as the value of a stock is valid only within the context of the model and its limitations) The above rubric will be applied to grade each question and the average score will be calculated for each subcomponent. 4