Workshop 2 - Answers PDF

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BFW2140 CORPORATE FINANCE WORKSHOP 2 MC QUESTIONS TOPIC: Valuation of Securities BOND VALUATION 1. The current yield on a bond is equal to ________. A. annual interest payment divided by the current market price B. the yield to maturity C. annual interest divided by the par value D. the internal rate of return Current Yield = Annual coupon payment/Current market price 2. If a 7% coupon bond is trading for $975.00, it has a current yield of ____________ percent. A. 7.00 B. 7.24 C. 8.53 D. 7.18 Current Yield = 70/975 = 7.18. 3. A coupon bond pays annual interest, has a par value of $1,000, matures in 4 years, has a coupon rate of 10%, and has a yield to maturity of 12%. The current yield on this bond is ___________. A. 10.65% B. 10.45% C. 10.95% D. 10.52% FV = 1000, n = 4, PMT = 100, i = 12, PV = 939.25; CY = $100/$939.25 = 10.65%. 4. Of the following four investments, ________ is considered the safest. A. commercial paper B. corporate bonds C. Treasury bonds D. Treasury bills Only Treasury issues are insured by the government; the shorter the term of the instrument, the safer the instrument. 5. The ______ is a measure of the average rate of return an investor will earn if the investor buys the bond now and holds until maturity. A. current yield B. dividend yield C. P/E ratio D. yield to maturity The yield to maturity is a measure of the average rate of return an investor will earn if the investor buys the bond now and holds until maturity. 1

6. A coupon bond is a bond that _________. A. pays interest on a regular basis (typically every six months) B. does not pay interest on a regular basis but pays a lump sum at maturity C. can always be converted into a specific number of shares of common stock in the issuing company D. always sells at par A coupon bond will pay the coupon rate of interest on a regular basis unless the firm defaults on the bond. Convertible bonds are specific types of bonds. 7. A coupon bond that pays interest annually is selling at par value of $1,000, matures in 5 years, and has a coupon rate of 9%. The yield to maturity on this bond is: A. 8.0% B. 8.3% C. 9.0% D. 10.0% When a bond sells at par value, the coupon rate is equal to the yield to maturity. 8. A coupon bond that pays interest semi-annually is selling at $1,100, matures in 7 years, and has a coupon rate of 8.6%. The yield to maturity on this bond is: A. 6.40% B. 6.78% C. 9.90% D. 8.60% When a bond sells at premium value, the coupon rate is more than the yield to maturity. FV = 1000, PMT = 86, n = 14, PV = -1,200, I = 3.39 x 2 = 6.78% 9. A coupon bond that pays interest annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be ______ if the coupon rate is 7%. A. $712.99 B. $620.92 C. $1,123.01 D. $886.28 FV = 1000, PMT = 70, n = 5, i = 10, PV = 886.28. 10. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 8%. The intrinsic value of the bond today will be __________ if the coupon rate is 10%. A. $922.78 B. $924.16 C. $1,081.11 D. $1,077.20 FV = 1000, PMT = 50, n = 10, i = 4, PV = $1,081.11

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11. You purchased an annual interest coupon bond one year ago that now has 6 years remaining until maturity. The coupon rate of interest was 10% and par value was $1,000. At the time you purchased the bond, the yield to maturity was 8%. The amount you paid for this bond one year ago was A. $1,057.50. B. $1,075.50. C. $1,088.50. D. $1,104.13. FV = 100, PMT = 100, n = 7, i = 8, PV = 1104.13 12. A zero-coupon bond has a yield to maturity of 9% and a par value of $1,000. If the bond matures in 8 years, the bond should sell for a price of _______ today. A. 422.41 B. $501.87 C. $513.16 D. $483.49 PV => $1,000/(1.09)8 = $501.87 STOCK VALUATION 1. High P/E ratios tend to indicate that a company will ______, ceteris paribus. A. grow quickly B. grow at the same speed as the average company C. grow slowly D. not grow Investors pay for growth; hence the high P/E ratio for growth firms; however, the investor should be sure that he or she is paying for expected, not historic, growth. 2. ________ are analysts who use information concerning current and prospective profitability of a firm to assess the firm's fair market value. A. Credit analysts B. Fundamental analysts C. Systems analysts D. Technical analysts Fundamentalists use all public information in an attempt to value stock (while hoping to identify undervalued securities). 3. The _______ is defined as the present value of all cash proceeds to the investor in the stock. A. dividend payout ratio B. intrinsic value C. market capitalization rate D. plowback ratio The cash flows from the stock discounted at the appropriate rate, based on the perceived riskiness of the stock, the market risk premium and the risk free rate, determine the intrinsic value of the stock. 3

4. A preferred stock will pay a dividend of $2.75 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 10% on this stock. Use the constant growth DDM to calculate the intrinsic value of this preferred stock. A. $0.275 B. $27.50 C. $31.82 D. $56.25 E. None of these is correct P0 => 0.75/0.10 = $27.50 5. Low Tech Company has an expected ROE of 10%. The dividend growth rate will be ________ if the firm follows a policy of paying 40% of earnings in the form of dividends. A. 6.0% B. 4.8% C. 7.2% D. 3.0% E. None of these is correct g = ROE x retention ratio => 10% × 0.60 = 6.0%. 6. Sure Tool Company is expected to pay a dividend of $2 in the upcoming year. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. Analysts expect the price of Sure Tool Company shares to be $22 a year from now. The beta of Sure Tool Company's stock is 1.25. The market's required rate of return on Sure's stock is ____. A. 14.0% B. 17.5% C. 16.5% D. 15.25% Using CAPM: Re = 4% + 1.25(14% −4%) = 16.5%. 7. Exercise Bicycle Company is expected to pay a dividend in year 1 of $1.20, a dividend in year 2 of $1.50, and a dividend in year 3 of $2.00. After year 3, dividends are expected to grow at the rate of 10% per year. An appropriate required return for the stock is 14%. The stock should be worth _______ today. A. $33.00 B. $39.86 C. $55.00 D. $40.68 Calculations are shown in the table below.

P3 = 2 (1.10)/(0.14 −0.10) = $55.00; PV of P3 = $55/(1.14)3 = $37.12; PO = $3.56 + $37.12 = $40.68. 4

8. Sales Company paid a $1.00 dividend per share last year and is expected to continue to pay out 40% of earnings as dividends for the foreseeable future. If the firm is expected to generate a 10% return on equity in the future, and if you require a 12% return on the stock, the value of the stock is _______. A. $17.67 B. $13.00 C. $16.67 D. $18.67 E. None of these is correct g = 10% X 0.6 = 6%; P0 = 1 (1.06)/(0.12 −0.06) = $17.67. 9. Assume that Bolton Company will pay a $2.00 dividend per share next year. After that, the dividend is expected to increase at a constant rate of 5%. If you require a 12% return on the stock, the value of the stock is _______. A. $28.57 B. $28.79 C. $30.00 D. $31.78 E. None of these is correct P1 = 2 (1.05)/(.12 −.05) = $30.00; PV of P1 = $30/1.12 = $26.78; PV of D1 = 2/1.12 = 1.79; PO = $26.78 + $1.79 = $28.57. 10. An issue of common stock is selling for $57.20. The year-end dividend is expected to be $2.32 assuming a constant growth rate of 4%. What is the required rate of return? A. 10.03% B. 10.01% C. 8.06% D. None of the above Re = [D1/P0] + g = [2.32/57.20] + 0.04 = 8.06%

PRACTICE SET QUESTION (20 MCQS) 1. A bond which has a yield to maturity greater than its coupon interest rate will sell for a price A. below par OR discount B. at par. C. above par OR premium D. what is equal to the face value of the bond plus the value of all interest payments. Answer: A

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2. A 20-year bond pays 6% on a face value of $1,000. If similar bonds are currently yielding 5%, what is the intrinsic value of the bond? A. over $1,100 B. under $1,000 C. under $900 D. not enough information given to tell Answer: A: Coupon rate > YTM -> selling at a premium 3. A ten-year bond, with par value equals $1000, pays 7% annually. If similar bonds are currently yielding 6% annually, what is the market value of the bond? Use semi-annual analysis. A. $700.00 B. $927.50 C. $1,074.39 D. $1,520.70 Answer: C: FV=1000; 1/Y=3: PMT=35; N=20; CPT PV=$1074.39 4. A 10-year zero-coupon bond that yields 5% percent is issued with a $1000 par value. What is the issuance price of the bond (round to the nearest dollar)? A. $614 B. $64 C. $6,140 D. none of these Answer: A: N=10; FV=1000; 1/Y=5; CPT PV=613.91 5. A 15-year zero-coupon bond was issued with a $1000 par value to yield 8%. What is the approximate intrinsic value of the bond? A. $597 B. $315 C. $275 D. $482 Answer: B: N=15; FV=1000; 1/Y=8; CPT PV= 315.24 6. Which of the following does not influence the yield to maturity for a security? A. required real rate of return B. risk free rate C. business risk D. historic yields Answer: D 7. A ten-year bond pays 7% interest on a $1000 face value annually. If it currently sells for $1,195, what is its approximate yield to maturity? A. 9.33% B. 3.46% C. 5.34% D. 4.53% Answer: D: N=10; FV=1000; PMT=70; PV=-1195; CPT 1/Y = 4.53

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8. The relationship between a bond's price and the yield to maturity A. changes at a constant level for each percentage change of yield to maturity. B. is an inverse relationship. C. is a linear relationship. D. A and B. Answer: B 9. An issue of preferred stock is paying an annual dividend of $1.50. The growth rate for the firm's common stock is 5%. What is the preferred stock price if the required rate of return is 7%? A. $21.43 B. $30.00 C. $22.50 D. none of these Answer: A: P0 = 1.50/0.07 =>$21.428 10. Which is a characteristic of the price of preferred stock? A. Since preferred stock dividends are fixed, they are tax deductible. B. Because preferred stock has no maturity, the price analysis is similar to that of debt. C. Preferred stock is valued as a perpetuity. D. None of these. Answer: C 11. An issue of common stock’s most recent dividend is $1.75. Its growth rate is 5.7%. What is its price if the market's rate of return is 7.7%? A. $24.63 B. $87.50 C. $92.49 D. none of these Answer: C: [1.75 (1.057)]/(0.077-0.057) = 92.49 12. An issue of common stock is expected to pay a dividend of $5.15 at the end of the year. Its growth rate is equal to 6%. If the required rate of return is 10%, what is its current price? A. $128.75 B. $36.92 C. $96.00 D. none of these Answer: A: [5.15]/(0.10-0.06) = 128.75 13. If expected dividends grow at 7% and the appropriate discount rate is 9%, what is the value of a stock with an expected dividend of $1.00? A. $62.88 B. $19.41 C. $29.12 D. $50.00 Answer: D: [1]/(0.09-0.07) = $50

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14. Stock valuation models are dependent upon A. expected dividends, future dividend growth and an appropriate discount rate. B. past dividends, flotation costs and bond yields. C. historical dividends, historical growth and an appropriate discount rate. D. all of these. Answer: A 15. An issue of common stock has just paid a dividend of $2.00. Its growth rate is equal to 4%. If the required rate of return is 7%, what is its current price? A. $19.04 B. $80.00 C. $69.33 D. none of these Answer: C: [2 (1.04)]/(0.07-0.04) = $69.33

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