Block Foundations of Financial Management 17e Chap010 SM PDF

Preview

Summary

Book Answers...

Description

Chapter 10: Valuation and Rates of Return

Chapter 10 Valuation and Rates of Return

Discussion Questions 10-1.

How is valuation of any financial asset related to future cash flows? The valuation of a financial asset is equal to the present value of future cash flows.

10-2.

Why might investors demand a lower rate of return for an investment in Microsoft as compared to United Airlines? Because Microsoft has less risk than United Airlines, Microsoft has relatively high returns and a strong market position; United Airlines has had financial difficulties and emerged from bankruptcy in 2006.

10-3.

What are the three factors that influence the required rate of return by investors? The three factors that influence the demanded rate of return are: a. The real rate of return b. The inflation premium c. The risk premium

10-4.

If inflationary expectations increase, what is likely to happen to yield to maturity on bonds in the marketplace? What is also likely to happen to the price of bonds? If inflationary expectations increase, the yield to maturity (the required rate of return) will increase. This will mean a lower bond price.

10-5.

Why is the remaining time to maturity an important factor in evaluating the impact of a change in yield to maturity on bond prices? The longer the time period remaining to maturity, the greater the impact of a difference between the rate the bond is paying and the current yield to maturity (required rate of return). For example, a 2 percent ($20) differential is not very significant for one year, but very significant for 20 years. In the latter case, it will have a much greater effect on the bond price.

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

10-6.

What are the three adjustments that have to be made in going from annual to semiannual bond analysis? The three adjustments in going from annual to semiannual bond analysis are: 1. Divide the annual interest rate by two. 2. Multiply the number of years by two. 3. Divide the annual yield to maturity by two.

10-7.

Why is a change in required yield for preferred stock likely to have a greater impact on price than a change in required yield for bonds? The longer the life of an investment, the greater the impact of a change in the required rate of return. Since preferred stock has a perpetual life, the impact is likely to be at a maximum.

10-8.

What type of dividend pattern for common stock is similar to the dividend payment for preferred stock? The no-growth pattern for common stock is similar to the dividend on preferred stock.

10-9.

What two conditions must be met to go from Formula 10-7 to Formula 10-8 in using the dividend valuation model? P0 

D1 Ke  g

 10-8 

To go from Formula (10-7) to Formula (10-8): The firm must have a constant growth rate (g). The discount rate (Ke) must exceed the growth rate (g). 10-10.

What two components make up the required rate of return on common stock? The two components that make up the required rate of return on common stock are: a. The dividend yield D1/P0. b. The growth rate (g). This actually represents the anticipated growth in dividends, earnings, and stock price over the long term.

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

10-11.

What factors might influence a firm’s price-earnings ratio? The price-earnings ratio is influenced by the earnings and sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend policy, the quality of management, and a number of other factors. Firms that have bright expectations for the future tend to trade at high P/E ratios while the opposite is true of low P/E firms.

10-12.

How is the supernormal growth pattern likely to vary from the normal, constant growth pattern? A supernormal growth pattern is represented by very rapid growth in the early years of a company or industry that eventually levels off to more normal growth. The supernormal growth pattern is often experienced by firms in emerging industries, such as in the early days of electronics or microcomputers.

10-13.

What approaches can be taken in valuing a firm’s stock when there is no cash dividend payment? In valuing a firm with no cash dividend, one approach is to assume that at some point in the future a cash dividend will be paid. You can then take the present value of future cash dividends. A second approach is to take the present value of future earnings as well as a future anticipated stock price. The discount rate applied to future earnings is generally higher than the discount rate applied to future dividends.

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

Chapter 10

Problems (For the first 20 bond problems, assume interest payments are on an annual basis.) 1.

Bond value (LO10-3) The Lone Star Company has $1,000 par value bonds outstanding at 10 percent interest. The bonds will mature in 20 years. Compute the current price of the bonds if the present yield to maturity is a. 6 percent. b. 9 percent. c. 13 percent.

10-1. Solution: Loan Star Company Calculator Solution: (a) 6 percent yield to maturity N I/Y 20 6

PV CPT PV −1,458.80

PMT 100

FV 1,000

PMT 100

FV 1,000

PMT 100

FV 1,000

Answer: $1,458.80 Current bond price (b) 9 percent yield to maturity N I/Y 20 9

PV CPT PV −1,091.29

Answer: $1,091.29 Current bond price (c) 13 percent yield to maturity N I/Y 20 13

PV CPT PV −789.26

Answer: $789.26 Current bond price

a. 6 percent yield to maturity Present Value of Interest Payments Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

PVA = A × PVIFA (n = 20, i = 6%) PVA = 100 × 11.470 = $1,147.00

Appendix D

Present Value of Principal Payment at Maturity PV = FV × PVIF (n = 20, i = 6%) Appendix B PV = 1,000 × .312 = $312 Total Present Value Present Value of Interest Payments Present Value of Principal Payment Total Present Value or Price of the Bond

$1,147.00 312.00 $1,459.00

10-1. (Continued) b. 9 percent yield to maturity PVA = A × PVIFA (n = 20, i = 9%) PVA = $100 × 9.129 = $912.90 PV = FV × PVIF (n = 20, i = 9%) PV = $1,000 × .178 = $178.00

Appendix D Appendix B $ 912.90 178.00 $1,090.90

c. 13 percent yield to maturity PVA = A × PVIFA (n = 20, i = 13%) PVA = $100 × 7.025 = $702.50

Appendix D

PV = FV × PVIF (n = 20, i = 13%) PV = $1,000 × .087 = $87.00

Appendix B $702.50 87.00 $789.50

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

2.

Midland Oil has $1,000 par value bonds outstanding at 8 percent interest. The bonds will mature in 25 years. Compute the current price of the bonds if the present yield to maturity is a. 7 percent. b. 10 percent. c. 13 percent.

10-2. Solution: Midland Oil Calculator Solution: (a) 7 percent yield to maturity N I/Y 25 7

PV CPT PV −1,116.54

PMT 80

FV 1,000

PV CPT PV −818.46

PMT 80

FV 1,000

PV CPT PV −633.50

PMT 80

FV 1,000

Answer: $1,116.54 Current bond price (b) 10 percent yield to maturity N I/Y 25 10 Answer: $ 818.46 Current bond price (c) 13 percent yield to maturity N I/Y 25 13 Answer: $633.50 Current bond price

a. 7 percent yield to maturity Present Value of Interest Payments PVA = A × PVIFA (n = 25, i = 7%) PVA = $80 × 11.654 = $932.32

Appendix D

Present Value of Principal Payment at Maturity PV = FV × PVIF (n = 25, i = 7%) Appendix B Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

PV = $1,000 × .184 = $184 Total Present Value Present Value of Interest Payments Present Value of Principal Payments Total Present Value or Price of the Bond b. 10 percent yield to maturity PVA = A × PVIFA (n = 25, i = 10%) PVA = $80 × 9.077 = $726.16 PV = FV × PVIF (n = 25, i = 10%) PV = $1,000 × .092 = $92

$ 932.32 184.00 $1,116.32 Appendix D

Appendix B $726.16 92.00 $818.16

10-2. (Continued)

c. 13 percent yield to maturity PVA = A × PVIFA (n = 25, i = 13%) PVA = $80 × 7.330 = $586.40 PV = FV × PVIF (n = 25, i = 13%) PV = $1,000 × .047 = $47

Appendix D Appendix B $586.40 47.00 $633.40

3.

Exodus Limousine Company has $1,000 par value bonds outstanding at 10 percent interest. The bonds will mature in 50 years. Compute the current price of the bonds if the percent yield to maturity is a. 5 percent. b. 15 percent. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

10-3. Solution: Exodus Limousine Company Calculator Solution: (a) 5 percent yield to maturity N I/Y 50 5

PV CPT PV −1,912.80

PMT 100

FV 1,000

PMT 100

FV 1,000

Answer: $1,912.80 Current bond price (b) 15 percent yield to maturity N I/Y 50 15

PV CPT PV −666.97

Answer: $666.97 Current bond price

a. 5 percent yield to maturity Present Value of Interest Payments PVA = A × PVIFA (n = 50, i = 5%) PVA = $100 × 18.256 = $1,825.60

Appendix D

Present Value of Principal Payment PV = FV × PVIF (n = 50, i = 5%) PV = $1,000 × .087 = $87

Appendix B

Present Value of Interest Payment Present Value of Principal Payment Total Present Value or Price of the Bond

$1,825.60 87.00 $1,912.60

10-3. (Continued) b. 15 percent yield to maturity Present Value of Interest Payments Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

PVA = A × PVIFA (n = 50, i = 15%) PVA = $1,000 × 6.661 = $666.10

Appendix D

PV = FV × PVIF (n = 50, i = 15%) PV = $1,000 × .001 = $1

Appendix B

Present Value of Interest Payment Present Value of Principal Payment Total Present Value or Price of the Bond

4.

$666.10 1.00 $667.10

Bond value (LO10-3) Barry’s Steroids Company has $1,000 par value bonds outstanding at 16 percent interest. The bonds will mature in 40 years. If the percent yield to maturity is 13 percent, what percent of the total bond value does the repayment of principal represent?

10-4. Solution: Barry’s Steroids Calculator Solution: 13 percent yield to maturity N I/Y 40 13

PV CPT PV −1,229.03

PMT 160.0

FV 1,000

PMT 0

FV 1,000

Answer: $1,229.03 Total present value of the bond N 40

I/Y 13

PV CPT PV −7.53

Answer: $7.53 Present value of the principal payment PV of principal payment $7.53 = = .613% Bond value $1,229.03

Present Value of Interest Payments Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

PVA = A × PVIFA (n = 40, i = 13%) PVA = $160 × 7.634 = $1,221.44

Appendix D

Present Value of Principal Payment PV = FV × PVIF (n = 40, i = 13%) PV = $1,000 × .008 = $8.00

Appendix B

Present Value of Interest Payments Present Value of Principal Payment Total Present Value or Price of the Bond

$1,221.44 8.00 $1,229.44

PV of Principal Payment $8.00  .651% Bond Value $1, 229.44 5.

Bond value (LO10-3) Essex Biochemical Co. has a $1,000 par value bond outstanding that pays 15 percent annual interest. The current yield to maturity on such bonds in the market is 17 percent. Compute the price of the bonds for the following maturity dates: a. 30 years b. 20 years c. 4 years

10-5. Solution: Essex Biochemical Calculator Solution: (a) 30 years to maturity N I/Y 30 17

PV CPT PV −883.41

PMT 150.0

FV 1,000

PV CPT PV −887.44

PMT 150.0

FV 1,000

Answer: $883.41 Bond price (b) 20 years to maturity N I/Y 20 17

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

Answer: $887.44 Bond price (c) 4 years to maturity N 4

I/Y 17

PV CPT PV −945.14

PMT 150.0

FV 1,000

Answer: $945.14 Bond price

a. 30 years to maturity Present Value of Interest Payments PVA = A × PVIFA (n = 30, i = 17%) PVA = $150 × 5.829 = $874.35 PV = FV × PVIF (n = 30, i = 17%) PV = $1,000 × .009 = $9.00

Appendix D

Appendix B

Total Present Value Present Value of Interest Payments Present Value of Principal Payment Total Present Value or Price of the Bond

$874.35 9.00 $883.35

10-5. (Continued) b. 20 years to maturity PVA = A × PVIFA (n = 20, i = 17%) PVA = $150 ×5.628 = $844.20

Appendix D

PV = FV × PVIF (n = 20, i = 17%) PV = $1,000 × .043 = $43.00

Appendix B $ 844.20 43.00 $887.20

c. 4 years to maturity Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

PVA = A × PVIFA (n = 4, i = 17%) PVA = $150 × 2.743 = $411.45

Appendix D

PV = FV × PVIF PV = $1,000 × .534 = $534

Appendix B $ 411.45 534.00 $945.45

6.

Kilgore Natural Gas has a $1,000 par value bond outstanding that pays 9 percent annual interest. The current yield to maturity on such bonds in the market is 12 percent. Compute the price of the bonds for the following maturity dates: a. 30 years b. 15 years c. 1 year

10-6. Solution: Kilgore Natural Gas Calculator Solution: (a) 30 years to maturity N I/Y 30 12

PV CPT PV −758.34

PMT 90

FV 1,000

PV CPT PV −795.67

PMT 90

FV 1,000

Answer: $758.34 Bond price (b) 15 years to maturity N I/Y 15 12 Answer: $795.67 Bond price (c) 1 year to maturity N I/Y 1 12 Answer: $973.21 Bond price

PV CPT PV −973.21

PMT 90

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

FV 1,000

Chapter 10: Valuation and Rates of Return

a. 30 years to maturity Present Value of Interest Payments PVA = A × PVIFA (n = 30, i = 12%) PVA = $90 × 8.055 = $724.95 PV = FV × PVIF (n = 30, i = 12%) PV = $1,000 × .033 = $33

Appendix D Appendix B

Total Present Value Present Value of Interest Payments Present Value of Principal Payment Total Present Value or Price of the Bond

$724.95 33.00 $757.95

10-6. (Continued) b. 15 years to maturity PVA = A × PVIFA (n = 15, i = 12%) PVA = $90 × 6.811 = $612.99

Appendix D

PV = FV × PVIF (n = 15, i = 12%) PV = $1,000 × .183 = $183

Appendix B $612.99 183.00 $795.99

c. 1 year to maturity PVA = A × PVIFA PVA = $90 × .893 = $80.37

Appendix D

PV = FV × PVIF PV = $1,000 × .893 = $893.00

Appendix B $ 80.37 893.00

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

$973.37 7.

Bond maturity effect (LO10-3) Toxaway Telephone Company has a $1,000 par value bond outstanding that pays 6 percent annual interest. If the yield to maturity is 8 percent, and remains so over the remaining life of the bond, the bond will have the following values over time: Remaining Maturity 15 10 5 1

Bond Price $795.67 $830.49 $891.86 $973.21

Graph the relationship in a manner similar to the bottom half of Figure 10-2. Also explain why the pattern of price change takes place.

10-7. Solution: Toxaway Telephone Company

As the time to maturity becomes less and less, the importance of the difference between the rate the bond pays and the yield to maturity becomes less significant. Therefore, the bond trades closer to par value.

Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

8.

c.

Go to Table 10-1, which is based on bonds paying 10 percent interest for 20 years. Assume interest rates in the market (yield to maturity) decline from 11 percent to 8 percent: a. What is the bond price at 11 percent? b. What is the bond price at 8 percent? What would be your percentage return on investment if you bought when rates were 11 percent and sold when rates were 8 percent?

10-8. Solution: a. $920.30 b. $1,196.80 c. Sales price (8%)............................$1,196.36 Purchase price (11%).................... 920.30 Profit..............................................$ 275.99 Profit $275.99   29.99% Purchase Price $920.37

9.

Interest rate effect (LO10-3) Go to Table 10-1, which is based on bonds paying 10 percent interest for 20 years. Assume interest rates in the market (yield to maturity) increase from 9 to 12 percent. a. What is the bond price at 9 percent? b. What is the bond price at 12 percent? c. What would be your percentage return on the investment if you bought when rates were 9 percent and sold when rates were 12 percent?

10-9. Solution: a. $1,091.29 b. $850.61 c. Purchase price (9%)...................... $1,091.29 Sales Price (12%).......................... 850.61 Loss .............................................. ($240.68)  $240.68 Loss   22.05% Purchase Price $1,091.29 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10: Valuation and Rates of Return

10.

Interest rate effect (LO10-3) Using Table 10-1, assume interest rates in the market (yield to maturity) are 14 percent for 20 years on a bond paying ...