Module 5 Exercises

1. Current yield and yield to maturity

Assume that a $1,000-par-value bond has a coupon rate of 5% and will mature in 10 years. It has
a current price quote of $810.34. Given this information, answer the following questions.
a. What is the yield to maturity of the bond?

We assume that the bond makes interest payments annually.

Yield to maturity = RATE(10,1000*5%,-810.34,1000,0) = 7.80%

b. What is the current yield of the bond?

Current yield = 1000 * 5% / 810.34 = 6.17%

c. Why does the current yield differ from the yield to maturity?

It is because the bond has not matured yet. The current yield does not discount the interest
payments that would be received in the future whereas the yield to maturity does.

d. One year later, the market rates have increased to 8%. Assume that you have just
received a coupon payment and sold the bond. If you sold your bond at its intrinsic value,
what would the rate of return be on your investment?

Intrinsic value of bond = –PV(8%,9,1000*5%,1000,0) = $812.59

Rate of return on investment = 1000/(intrinsic value of bond) -1 = 23%

2. Basic bond valuation

Motorway Development Corporation builds and maintains highways across Europe. They have
an outstanding issue of $100-par-value bonds with an 8% coupon rate. The issue pays interest
annually and has 12 years remaining to its maturity date.
a. If bonds of similar risk are currently earning at 4% rate of return, how much should the
Motorway Development Corporation’s bond sell for today?

Bond current selling price = –PV(4%,12,100*8%,100,0) = $137.54

b. Describe the two possible reasons why the rate on similar-risk bonds is below the coupon
rate on the Motorway Development Corporation bonds.

Two possible reasons why the rate on similar-risk bonds is below the coupon rate of the
Motorway Development Corporation bonds are (1) supply and demand of money, and (2) risk
and return.
 c. If the required return were at 10% instead of 4%, what would the current value of
Motorway Development Corporation’s bonds be? Contrast this finding with your findings
in part a and discuss.

Bond current selling price = –PV(10%,12,100*4%,100,0) = $86.37

This value is lower than the one in part a because the required return increased. Moreover,
since the required return in part c surpasses the coupon rate, the current value decreased to lower
than the par value.

3. Bond value and changing required returns

Bond X has a coupon rate of 8% and Bond Y pays 4% annual coupon. Both bonds have 10 years
to maturity. The yield to maturity for both bonds is now 8%.
a. If the interest rate rises by 2%, by what percentage will the price of the two bonds
change?

For illustration purposes, let the par value of both bonds be 100.

Bond Price given 8% interest Price given 10% Percent decrease in

rate interest rate price
X 100.00 87.71 12.29
Y 73.16 63.13 13.71

Price given i% interest rate = –PV(i%,10,100*coupon rate,100,0)

Percent decrease in price
= (PV given 8% interest rate – PV given 10% interest rate) / PV given 8% interest rate

b. If the interest rate drops by 2%, by what percentage will the price of the two bonds
change?

Bond Price given 8% interest Price given 6% Percent increase in

rate interest rate price
X 100.00 114.72 14.72
Y 73.16 85.28 16.57

Percent increase in price

= (PV given 6% interest rate – PV given 8% interest rate) / PV given 8% interest rate

c. Which bond has more interest rate risk? Why?

Bond Y has more interest rate risk because its percent changes in price are higher than those
of Bond X. In other words, the price Bond Y changes to a greater extent in response to a change
in interest rate than Bond X does. Bond Y risks its price falling more than that of Bond X when
the interest rate increases.

4. Bond valuation: Semi-annual interest

Heather has just bought a bond that will mature in 5 years for $300, with a $320 par value and a
coupon rate of 10% paid semiannually. What should the value of this bond be if the required
return on similar-risk bonds is 12% per year (6% paid semiannually)

Bond value = –PV(6%,5*2,320*10%/2,320,0) = $296.45

5. Bond valuation: Quarterly interest

Calculate the value of a $1,000-par-value bond paying quarterly interest at an annual coupon rate
of 12% and having 8 years until maturity if the required return on similar risk bonds is currently
at 10% annual rate paid quarterly.

Bond value = –PV(10%/4,8*4,1000*12%/4,1000,0) = $1,109.25

6. Common stock valuation: Zero growth

Kelsey Drums Inc. is a well-established supplier of fine percussion instruments to orchestras all
over the United States. The company’s class A common stock has paid a dividend of $2.80 per
share per year for the last 12 years. Management expects to continue to pay at that amount for
the foreseeable future. Kim Arnold purchased 200 shares of Kelsey class A common stock 10
years ago at a time when the required return for the stock was 7.6%. She wants to seller her
shares today. The current required rate of return for the stock is 9.25%. How much capital gain
or loss will Kim have on her shares?

Stock value 10 years ago = dividend per share / required return = $36.84
Current stock value = dividend per share / required return = $30.27
Capital gain from shares = number of shares * (stock value 10 years ago – current stock value)
= $1,314.37

7. Common stock value: Constant growth

Sweet Candy will pay a dividend of $0.72 per share next year. The CEO of the company
declared that the company expects to maintain a constant growth rate of 7% per year every year
from now on.
a. What will be the price per share if the required return is 10%?

Price per share = 0.72 / (10% – 7%) = $24

b. What will be the price per share if the required return is 8%?

Price per share = 0.72 / (8% – 7%) = $72

c. Based on your answers in part a and b, give one disadvantage of the constant growth
model.
 The model does not take into account changes in required return. It is a disadvantage because
changes in required return could cause significant changes in the price per share. As observed
from our answers in part a and b, a 2% (10% - 8%) decrease in required return caused a
significant 200% [(72 – 24) / 24] increase in price per share.

8. Common stock value: Variable growth

Moors Tools is considering a cash purchase of the stocks of Crooks Moldings. During the year
just completed, Crooks earned $4.5 per share and paid cash dividends of $2.3 per share (D0 =
2.30). Crook’s earnings and dividends are expected to grow at 20% per year for the next 2 years,
after which they are expected to grow at 5% per year forever. What is the maximum price per
share that Moors should pay for Crooks if it has a required return of 12% on investments with
risk characteristics similar to those of Crooks?

A B
1 Year Dividends, $
2 0 2.30
3 1 2.76
4 2 3.31
5 3 3.48

Dividends at year t = –FV(20%,years from year 0,0,2.3,0) where t = {1, 2}

Dividends at year 3 = –FV(5%,years from year 0,0,2.3,0)

PV of dividends from years 1 to 2 = NPV(12%,B3:B4) = $5.10

PV of dividends from year 3 onwards = –PV(12%,3,0,B5/(12%-5%),0) = $39.60
Maximum price per share = PV of dividends from years 1 to 2 + PV of dividends from year 3
onwards = $44.71

9. Free cash flow valuation

Nabor Industries is considering going public but is unsure of a fair offering price for the
company. Before hiring an investment banker to assist in making the public offering, managers
at Nabor have decided to make their own estimate of the firm’s common stock value. The firm’s
CFO has gathered data for performing the valuation using the free cash flow valuation model.

The firm’s weighted average cost of capital is 11%, and it has $1,500,000 of debt and $400,000
of preferred stock in terms of market value. The estimated free cash flows over the next 5 years,
2020 through 2024, are given below. Beyond 2024 to infinity, the firm expects its free cash
flows to grow by 3% annually.

Year Free cash flow, $

2020 200,000
2021 250,000
2022 310,000
2023 350,000
 2024 390,000

a. Estimate the value of Nabor Industries’ entire company using the free cash flow valuation
model.

PV of cash flows until 2024 $ 1,071,756.98

PV of cash flows from 2025 onwards $ 2,979,867.48
Value of Nabor Industries’ entire company $ 4,051,624.46

PV of cash flows until 2024 = NPV(11%,free cash flows from 2020 to 2023)
PV of cash flows from 2025 onwards = –PV(11%,5,0,390000*(1+3%)/(11% - 3%),0)
Value of Nabor Industries’ entire company = NPV until 2023 + PV from 2024 onwards

b. Use your finding in part a, along with the data provided above, to find Nabor Industries’
common stock value

Common stock value = Value of Nabor Industries’ entire company – $1,500,000 – $400,000
= $2,151,624.46

c. If the firm plans to issue 200,000 shares of common stock, what is its estimated value per
share?

We assume that there are no previous shares of common stock outstanding.

Estimated value per share = Common stock value / 200,000 = $10.76

10. Book and liquidation value

The balance sheet for Gallinas Industries is as follows:

Assets
Cash $40,000
Marketable securities 60,000
Accounts receivable 120,000
Inventories 160,000
Total current assets 380,000
Land and buildings (net) 150,000
Machinery and equipment 250,000
Total fixed assets (net) 400,000
Total assets 780,000
Liabilities and stockholder’s equity
Accounts payable 100,000
Notes payable 30,000
Accrued wages 30,000
Total current liabilities 160,000
Long-term debt 180,000
Preferred stock 80,000
 Common stock (10,000 shares) 160,000
Retained earnings 100,000
Total liabilities and stockholder’s equity 780,000

Additional information with respect to the firm is available:

● Preferred stock can be liquidated at book value
● Accounts receivable and inventories can be liquidated at 90% of book value
● The firm has 10,000 shares of common stock outstanding
● All interest and dividends are currently paid up
● Land and buildings can be liquidated at 130% of book value
● Machinery and equipment can be liquidated at 70% of book value
● Cash and marketable securities can be liquidated at book value

Given this information, answer the following:

a. What is Gallinas Industries’ book value per share?

Book value per share = $[780,000 – (160,000 + 180,000 + 80,000)] / 10,000 = $36

b. What is its liquidation value per share?

Account Liquidation Value, thousand $

Cash 40
Marketable securities 60
Accounts receivable 108
Inventories 144
Land and buildings (net) 195
Machinery and equipment 175
Total assets 772

Liquidation value per share = $[772,000 – (160,000 + 180,000 + 80,000)] / 10,000 = $35.2

c. Compare, contrast, and discuss the values found in parts a and b

The firm’s book value per share is higher than its liquidation value per share. This is because
the firm sold its accounts receivable, inventories, and machinery and equipment below their book
values. Although the firm sold its land and buildings above their book value, the gain from this
sale is not enough to offset the loss from the sale of the assets sold below their book values.

11. Valuation with price/earnings multiples

For each of the firms shown in the following table, use the data given to estimate its common
stock value employing price/earnings (P/E) multiples

Firm Expected EPS, $ Price/earnings multiple

 A 3.00 6.3
B 0.75 15.2
C 1.80 5.7
D 2.50 11.20
E 3.2 8.40

Firm Common stock value, $

A 18.90
B 11.40
C 10.26
D 28.00
E 26.88

Common stock value = Expected EPS * (Price/earnings multiple)