Finance Home work.

Donaldson Chapters 6,7, and 8 Case Problems 4

Chapter 6: 6-1, 6-2, 6-5, 6-7, 6-15

Chapter 7: 7-7, 7-9, 7-13, 7-15, 7-21

Chapter 8: 8-15, 8-19, 8-25, 8-33, 8-34

6-1 Determinants of Interest Rates for Individual Securities A particular security’s default

risk premium is 2 percent. For all securities, the inflation risk premium is 1.75 percent and

the real interest rate is 3.5 percent. The security’s liquidity risk premium is 0.25 percent

and maturity risk premium is 0.85 percent. The security has no special covenants. Calcu-

late the security’s equilibrium rate of return. (LG6-4)

6-2 Determinants of Interest Rates for Individual Securities You are considering an invest-

ment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants.

The Wall Street Journal reports that 1-year T-bills are currently earning 1.25 percent. Your

broker has determined the following information about economic activity and Moore

Corporation bonds:

Real interest rate  5 0.75%

Default risk premium  5 1.15%

Liquidity risk premium  5 0.50%

Maturity risk premium  5 1.75%

a. What is the inflation premium? (LG6-4)

b. What is the fair interest rate on Moore Corporation 30-year bonds? (LG6-4)

6-5 Unbiased Expectations Theory Suppose that the current 1-year rate (1-year spot rate)

and expected 1-year T-bill rates over the following three years (i.e., years 2, 3, and 4,

respectively) are as follows:

1R1 56%, E(2r1) 57%, E(3r1) 57.5%, E(4r1) 57.85%

Using the unbiased expectations theory, calculate the current (long-term) rates for 1-, 2-,

3-, and 4-year-maturity Treasury securities. Plot the resulting yield curve. (LG6-5)

6-7 Liquidity Premium Hypothesis One-year Treasury bills currently earn 3.45 percent. You

expect that one year from now, 1-year Treasury bill rates will increase to 3.65 percent. The

liquidity premium on 2-year securities is 0.05 percent. If the liquidity theory is correct,

what should the current rate be on 2-year Treasury securities? (LG6-5)

6-15 Forecasting Interest Rates You note the following yield curve in The Wall Street Journal.

According to the unbiased expectations hypothesis, what is the 1-year forward rate for the

period beginning one year from today, 2 f 1 ? (LG6-6)

Maturity Yield

One day 2.00%

One year 5.50

Two years 6.50

Three years 9.00

7-7 TIPS Interest and Par Value A 2¾ percent TIPS has an original reference CPI of 185.4. If the

current CPI is 210.7, what is the current interest payment and par value of the TIPS? (LG7-2)

7-9 Bond Quotes Consider the following three bond quotes: a Treasury note quoted at 97:27,

a corporate bond quoted at 103.25, and a municipal bond quoted at 101.90. If the Treasury

and corporate bonds have a par value of $1,000 and the municipal bond has a par value of

$5,000, what is the price of these three bonds in dollars? (LG7-3)

7-13 Current Yield What’s the current yield of a 4.5 percent coupon corporate bond quoted at

a price of 102.08? (LG7-6)

7-15 Taxable Equivalent Yield What’s the taxable equivalent yield on a municipal bond with

a yield to maturity of 3.5 percent for an investor in the 33 percent marginal tax bracket?

(LG7-6)

7-21 Compute Bond Price Compute the price of a 4.5 percent coupon bond with 15 years left

to maturity and a market interest rate of 6.8 percent. (Assume interest payments are semi-

annual.) Is this a discount or premium bond? (LG7-4)

8-15 Value of Dividends and Future Price A firm is expected to pay a dividend of $1.35

next year and $1.50 the following year. Financial analysts believe the stock will be at their

price target of $75 in two years. Compute the value of this stock with a required return of

11.5 percent. (LG8-5)

8-19 Value a Constant Growth Stock Financial analysts forecast Safeco Corp.’s (SAF) growth

rate for the future to be 10 percent. Safeco’s recent dividend was $1.20. What is the value of

Safeco stock when the required return is 12 percent? (LG8-5)

8-25 P/E Ratio Model and Future Price Kellogg Co. (K) recently earned a profit of $2.52 earn-

ings per share and has a P/E ratio of 19.86. The dividend has been growing at a 5 percent

rate over the past few years. If this growth rate continues, what would be the stock price in

five years if the P/E ratio remained unchanged? What would the price be if the P/E ratio

declined to 15 in five years? (LG8-7)

8-33 Variable Growth A fast-growing firm recently paid a dividend of $0.35 per share. The

dividend is expected to increase at a 20 percent rate for the next three years. Afterwards, a

more stable 12 percent growth rate can be assumed. If a 13 percent discount rate is appro-

priate for this stock, what is its value? (LG8-6)

8-34 Variable Growth A fast-growing firm recently paid a dividend of $0.40 per share. The

dividend is expected to increase at a 25 percent rate for the next four years. Afterwards,

a more stable 11 percent growth rate can be assumed. If a 12.5 percent discount rate is

appropriate for this stock, what is its value? (LG8-6)