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3. Clives Pawn Shop charges an interest per month on loans to its customers. Like
all lenders, Clive must report an APR to consumers. If the effective annual rate
is 213.84%, what APR should the Clive report?
A.
B.
C.
D.
E.
213.84%
17.82%
120%
10%
615.53%
EAR = 213.84% = [(1 + r/12)12 1] 100
4. A loan where the borrower pays interest each period, and repays some of the
principal of the loan over time is called a(n) _____ loan.
A.
B.
C.
D.
E.
Continuous
Pure Discount
Amortized
Interest-Only
None of Above
5. Dexter Mills issued 20-year bonds a year ago at a coupon rate of 11.4%. The
bonds make semiannual payments. The yield-to-maturity on these bonds is
9.2%. What is the current bond price?
A. $985.55
B. $991.90
C. $1,192.16
D. $1,195.84
E. $1,198.00
6. Which one of the following bonds is the least sensitive to interest rate risk?
A. 3-year; 4 percent coupon
B. 3-year; 6 percent coupon
C. 5-year; 6 percent coupon
D. 7-year; 6 percent coupon
E. 7-year; 4 percent coupon
7. A stock pays a constant annual dividend and sells for $31.11 a share. If the rate
of return on this stock is 9%, what is the dividend amount?
A. $1.40
B. $1.80
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C. $2.20
D. $2.40
E. $2.80
$31.31 = X / 0.09
8. High Country Builders currently pays an annual dividend of $1.35 and plans on
increasing that amount by 2.5% each year. Valley High Builders currently pays
an annual dividend of $1.20 and plans on increasing its dividend by 3% annually.
Given this information, you know for certain that the stock of High Country
Builders' has a lower ______ than the stock of Valley High Builders.
A. market price
B. dividend yield
C. capital gains yield
D. total return
E. The answer cannot be determined based on the information provided.
A. 10.79 %
B. 12.60 %
C. 13.48 %
D. 14.42 %
E. 15.08 %
Average return = (0.07 + 0.25 + 0.14 - 0.15 + 0.16)/5 = 0.094
Standard deviation = [1/(5 - 1)] [(0.07 - 0.094)2 + (0.25 - 0.094)2 +(0.14 - 0.094)2
+(-0.15 - 0.094)2 + (0.16 - 0.094)2] = 15.08 %
Bond Price
YTM = 5%
YTM = 6%
YTM = 15%
YTM = 16%
$1,077.95
$1,000.00
$541.25
$509.09
Calculate the percentage change in bond price and explain their different levels of
price risk using the following 2 cases:
(1) If required yield increases from 15% to 16%
(2) If required yield increases from 5% to 6%
(1) The bond price falls (in percentage) is: $509.09 $541.25 = 0.059409
$541.25
(2) The bond price falls (in percentage) is: ($1,000.00 $1,077.95) / $1,077.95 =
0.072310
We can conclude that there is more volatility in a low-interest-rate environment
because there was a greater fall (
7.23% versus 5.94%).
Question 2
Clive Inc., has 11% coupon bonds making annual payments with a YTM of 8.5%.
The current yield on these bonds is 9.06%. How many years do these bonds have
left until they mature?
Current yield = 0.0906 = $110/P0
P0 = $110/.0906 = $1,214.13
P0 = $1,214.13 = $110[(1 (1/1.085)t ) / 0.085 ] + $1,000/1.085t
t = 15.96 16 years
Question 3
The current dividend yield on Clayton's Metals common stock is 2.5%. The company
just paid a $1.48 annual dividend and announced plans to pay $1.54 next year. The
dividend growth rate is expected to remain constant at the current level. What is the
required rate of return on this stock?
(2) - (1)
PVA =
C
r
1
1 (1 + r ) n
C
1
1
(1 + r ) n
n
r (1 + r )
(1 + r ) n 1
FVA = C
Annuity Due
An annuity for which cash flows occur at the beginning of the period
Annuity Due = Ordinary Annuity (1 + r)
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APR vs EAR
APR: Annualized interest rate based on simple interest
APR = periodic rate m
EAR: Annualized interest rate based on compound interest; actual rate interest
earned/paid
EAR = (1+APR/m)m -1
Example:
A credit card charges 18% APR compounded monthly; What is the EAR?
APR = 18%, and m = 12, so periodic rate = 15% / 12 = 1.5%
EAR = (1+1.5%)12 1 = 19.56%
What APR must the store report to its customers? APR = 52(7%) = 364%
What EAR are customers actually paying? EAR = (1 + .07)52 1 = 3,273.53%
Things to Remember:
You ALWAYS need to make sure that the interest rate and the time period match:
(1) If you are looking at annual periods, you need an annual rate.
(2) If you are looking at monthly periods, you need a monthly rate.
*If you have an APR based on monthly compounding but your cash flow periods are
not monthly, you can first convert APR to EAR and then get the appropriate periodic
rate
HW#1 Question 5
Assume that you are planning to save for the education for your child. You
want to let your child study in US when he gets to high school at the age
of 15 that is exactly 10 years from today. You expect your child will stay
and study overseas for 7 years. You estimate that he needs to withdraw
$400,000 per year for 7 years beginning on his 15th birthday to cover tuition
and living expenses. You intend to invest in a mutual fund which offers 9%
APR compounded semi-annually.
(a) If you have decided to make one lump sum payment today to get enough
money for your child, how much should you invest today? (Convert it
to EAR first)
(b) If you make semi-annual contribution starting six months from now,
how many contributions will you make? How much should you invest
each time? Assume that you will make the last contribution when your
son turns 15. (Apply 9%, which is also the periodic rate)
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(c) If you make monthly contribution starting today, what amount should
you deposit each time? Assume that you will make the last contribution
when your son turns 15. (Convert it to EAR first)
Loan Types
(i)
Pure Discount loan
Pays the lump sum on expiration, no periodical payment; e.g. T-bills
(ii) Interest-only loan
Pays interests in each period and principal on expiration; e.g. corporate bonds, Tbonds
(iii) Amortized loan
Amortizing the principal into the same periodical payments; the total payment in
each period is reducing over time
- Fixed amount of principal
- Fixed amount of total payments (principal and interest) each period, e.g.
Personal Loans & Mortgages
schedule for a nine-year loan of $90,000 which requires equal annual payments. The
interest rate is 4.5% per year.
Year
Beginning
Balance
Total
Payment
Interest
Payment
Principal
Payment
Ending
Balance
1
2
3
4
5
90,000.00
81,668.30
72,961.67
63,863.24
54,355.39
12,381.70
12,381.70
12,381.70
12,381.70
12,381.70
4,050.00
3,675.07
3,283.28
2,873.85
2,445.99
8,331.70
8,706.63
9,098.43
9,507.86
9,935.71
81,668.30
72,961.67
63,863.24
54,355.39
44,419.68
10
6
7
8
9
44,419.68
34,036.86
23,186.81
11,848.52
12,381.70
12,381.70
12,381.70
12,381.70
1,998.89
1,531.66
1,043.41
533.18
10,382.82
10,850.04
11,338.30
11,848.52
34,036.86
23,186.81
11,848.52
0.00
FV + Ct
C
C
+
+ ... +
1
2
(1 + r) (1 + r)
(1 + r)t
C
r
1
1 (1 + r ) n
PV =
Coupon
1 Face
1
+
n
t
r
(1 + r ) (1 + r )
Given that bond make annual coupon payment periodically, i.e. m 1, the bond
pricing formula becomes:
(1) Par Bond: Bond sells at a face value (of $1,000) if coupon rate = market
interest rate
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(2) Discount Bond: Bond sells at a discount if coupon rate < market interest rate
(3) Premium Bond: Bond sells at a premium if coupon rate > market interest rate
Bond Yields
Current Yield
Annual coupon payments divided by bond price.
Yield to Maturity (YTM)
(i)
Interest rate for which the present value of bond equal the market price
(ii) Total annual expected return if you buy the bond today and hold to maturity
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(3) Supernormal growth: Dividends have a mixed growth rate pattern; that is,
If we forecast no growth for the stock (i.e. dividends keep constant forever), the
stock will become a perpetuity:
P0 =
D
R
As long as the growth rate, g, is less than the discount rate, R, the present value of
this series of cash flows can be written as:
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In other words, the constant-growth dividend model tells us that the current price of
a share of stock is the next period dividend divided by the difference between the
discount rate and the dividend growth rate.
This constant growth model or the Gordon model is used to find the value of a
stock whose dividend is expected to grow at a constant rate (g) forever. The value
obtained, P0, is the theoretical or intrinsic value of the stock.
The basic assumption for the model to hold requires R > g. Why do we assume
that R > g?
(1) R may be less than g in the short-run. The supernormal growth problem is an
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During the early part of their lives, very successful firms experience a super-normal
rate of growth in earnings.
- Given that growth rate cannot exceed the required return indefinitely, but it
certainly could do so for some number of years.
- To avoid the problem of having to forecast and discount an infinite number of
dividends, we will require that the dividends start growing at a constant rate
sometime in the future.
- 3-Steps Valuation:
- Estimate the dividend during non-constant growth period
- Estimate the PV of the constant growth dividends at the end of non-constant
growth period which is also the beginning of the constant growth period
- Get the present value of the above two values
Example: The growth rate for firm ABC is expected to be 20% for next two
years, and 6% thereafter. The current dividend is $1.60, and the firms required
rate of return is 10%. Whats stock worth today?
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Example: The next dividend payment by Carroll, Inc., will be $1.90 per share. The
dividends are anticipated to maintain a 5.5 percent growth rate, forever. If the stock
currently sells for $47.00 per share, what is the dividend yield? What is the expected
capital gains yield?
(1) Dividend yield = D1 / P0
Dividend yield = $1.90 / $47.00 = 4.04%
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Financial Manager
Corporate Structure
The Goal of the Financial Management
Agency Problem
Financial Markets
Problem Solving: Computation of Bond Price, Current Yield, Capital Gain Yield;
Real rate and Inflation rate (Fisher Equation)
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