FINA 4221 Principles of Corporate Finance

Professor Richard T. Thakor

Spring 2018

Problem Set 1
Due at the beginning of class on 1/24/2018

IMPORTANT: Be sure to show your work or explain the inputs you used in Excel, in order
to receive partial credit.

1. As winner of the Midas Touch Prime Lottery, you can choose one of the following
prizes:

(a) $60,000,000 now

(b) $80,000,000 at the end of 6 years
(c) $8,000,000 a year for 10 consecutive years. The first payment is in exactly one
year.
(d) $2,550,000 a year forever. The first payment is in exactly one year.
(e) $1,250,000 one year from now which increases by 2% a year forever

If the term structure of interest rates is flat at 4%, which is the most valuable prize?

2. The three U.S. Treasury bonds described below are traded in the market and pay
annual coupons. Assume that the par amount for each bond is $100.

Bond Maturity (Yr) Coupon Rate (%)

A 1 3.5
B 2 5.0
C 3 4.5

Assume that the 1-year interest rate is 3%, the 2-year interest rate is 4%, and the
3-year interest rate is 5%.

(a) Write out each bond’s cash flow for each year.
(b) Find each bond’s price.
(c) Suppose the Treasury plans to issue a new 3-year note with a $1,000 face value
and annual coupons. What coupon rate would they need to set for the bond to
initially trade at a price of $1,000?

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3. Consider the following three stocks:

• Stock A is expected to provide a dividend of $10 a share forever starting at the

end of the first year (time t = 1).
• Stock B is expected to pay a dividend of $5 at the end of the first year (time
t = 1). Thereafter, dividend growth is expected to be 4 percent a year forever.
• Stock C is expected to pay a dividend of $5 at the end of the first year (time
t = 1). Thereafter, dividend growth is expected to be 20 percent a year for 5
years (ending at time t = 6) and then zero (i.e. the dividends stop growing)
thereafter.

If the discount rate for each stock is 10 percent, what is the price of each stock?

4. You are looking to figure out what a company’s stock price should be. It is expected
to pay a dividend of $10 per share next year, and grow that dividend at a rate of 2%
each year after that. The financial analyst that you hired crunched some numbers, and
is confident that the beta of the stock is 0.8. The current risk-free interest rate is 1%,
and the market return is 10%.

(a) What should the company’s stock price be?

(b) Suppose that your analyst made a mistake, and the beta of the stock is actually
1.2. What should the company’s stock price be now?