Australian School Of Business FINS1613:

Business Finance Tutorial Quiz

Extra Practice Questions: Bonds & Equities

Name: SAMPLE SOLUTION

Student number: z0000000

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1. Which of the following statements is true if the probability that a firm will
default on its existing bonds decreases?
i. The yield to maturity will increase
ii. The price of the bond will decrease
iii. The coupon payments will decrease

Answer: None of the above.

If the probability a firm will default decreases, then the price of the bond
will increase and the corresponding yield to maturity will decrease. Coupon
payments are not affected.

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2. Hank is going to invest in Globex Corp. His expected rate of return is 27.9%.
He does not expect to recieve any dividend at the end of year 1 or year 2.
But, he believe the firm will pay a dividend of $1.79 per share at the end
of year 3. He also expects to the stock to have a price of $43.80 per share
at the end of year 3 (after Globex pays its dividend). If Hank plans to hold
onto the stock forever, how much should he be willing to pay for this stock
today?

Answer: $21.79
Using the dividend discount model, the price of a stock reflects the discounted
value of all future dividends. In other words, the investment horizon doesn’t
matter. The expected year 3 price reflects the value of future dividends.
Therefore, discount the year 3 dividend and year 3 stock price.

1.79 + 43.80
P rice = = 21.79.
1.2793

This is based on the MyFinanceLab equity assignment, question 3

on Acap Corporation. That question shows that all that is required
to price a stock is the dividends up to a point in time and the
expected price of the stock at that point in time.

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3. Prescott Pharmaceuticals will pay an annual dividend of $0.42 one year
from now at t=1. Analysts expect this dividend to grow at 19% per year
thereafter until the end of year 24. Dividends are then expected to be stable
until t=31. Afterwards, dividends decline at a rate of 3% annually (the
dividend at t=32 is 3% smaller than the payment at t=31 ) and are paid in
perpetuity. According to the dividend-discount model, what is the value of
a Prescott Pharmaceuticals share if the firm’s equity cost of capital is 14%?
Answer: d

The dividend payments consist of a twenty-four year growing annuity, a

seven-year constant annuity growing perpetuity (from t=24 to t=31), and a
constantly declining perpetuity. The value of the growing annuity is given
by:
  n 
1 1+g
Growing Annuity V aluet=0 = Divt=1 × 1−
r−g 1+r
"  24 #
1 1.19
= 0.42 × 1−
.14 − .19 1.14
= 15.13

Valuing the constant annuity requires determining the dividend in year 25.
If the year 1 dividend grows by 19% each year until year 24, then it grows
over 23 years. So, Div24 = Div1 × 1.1923 = 0.42 × 1.1923 = 22.952469. This
is the same dividend in year 24, Div25 = 22.952469.
   
Div25 1 22.952469 1
Constant Annuity V aluet=24 = 1− = 1−
r (1 + r)n .14 1.147
= 98.427182

The present value of the constantannuity is found by discounting the value

above twenty-four years to t = 0.
Constant Annuity V aluet=24 98.427182
Constant Annuity V aluet=0 = 24
= = 4.24
(1 + r) 1.1424

Finally, compute the value of the perpetuity. The first dividend occurs in
year 32 and is 3% smaller than the constant annuity dividends. Div32 =
22.952469×(1−.03) = 22.263895. The present time 0 value of this perpetuity
is given by:
Div32 22.263895 1
P erpetuity V aluet=0 = × 1(1 + r)31 = × = 2.25
r−g 0.14 − −0.03 1.1431

The total price of the stock is the total value of the three components:

P rice = 15.13 + 4.24 + 2.25 = 21.63

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4. Selfie Tick Corp manufacturers implantable cameras that document a cus-
tomers every moment of life. Investors expect earnings this year (at t=1 ) of
$6.51 per share. The firm pays 29% of earnings in dividends and reinvests
71% of earnings in new projects. The firm’s stock has a share price of $37.16,
which is based on a costant growth annual dividend discount model and a
cost of equity of 22.0%.
Selfie Tick will soon announce that is subject to class action law suits be-
cause the cameras occassionally make customers dangerously self-obsessed
and inclined to walk into oncoming traffic. It will settle these law suits,
resulting in earnings falling to $3.26 per share this year and lower earnings
in the future. The firm will also begin paying out 64% of all earnings as
dividends, retaining 36% for investment in new projects. What will be the
share price after this announcement? Investors are neither expecting the law
suit nor the firm’s response.
Answer: $15.55
The problem provides an initial stock price, earnings, a payout rate, and a
cost of equity. Dividends are simply the payout rate times earnings, Div =
1.8879. Therefore, the only missing variable in the dividend discount model
is the growth rate of dividends. Solve for this:

Div Div 1.8879

P = → g = ke − = 0.22 − = 0.169195
ke − g P 37.16
This growth rate is equal to the reinvestment rate times the return on new in-
g
vestment. Therefore, the return on new investment is reinvestment = 0.150490/0.71 =
0.238303.
Now, if the firm switches to reinvesting 36% of earnings, the new growth rate
in dividends will be 0.238303 × 0.36 = 0.085789. Plug this into the dividend
discount model with the post law-suit information:

Div 3.26 × 0.64

P = = = 15.55
ke − g 0.22 − 0.085789

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5. Abed’s Four Wall Demolition Co. expects earnings this year (at t=1 ) of
$11.5 million. It plans to pay a dividend of $3.1 million and spend $0.8
million repurchasing shares. Money reinvested will yield a return on new
investment of 23.9%. At the end of year 2, the firm plans to pay a dividend
of $2.0 million, spend $3.1 million repurchasing shares, and reinvest any
remaining earnings with a return on new investment of 13.0%. Finally, at
the end of year 3, the firm plans to pay a dividend of $1.7 million, spend
$8.5 million repurchasing shares, and reinvest any remaining earnings with
a return on new investment of 5.4%. The firm is expected to maintain the
year 3 dividend rate, repurchase rate,and return on new investment into
perpetuity. If the company will make annual payments forever, what is its
market value of equity at a discount rate of 10.3%?
Answer: $103.77
The stock can be valued by discounting all payouts. The question provides
information on the first two payouts. The value of payouts beginning in year
3 can be found using a constant perpetuity equation. To do that, determine
the earnings in each year. If earnings at t = 1 are $11.5 with dividends of
$3.1 and repurchases of $0.8, then the firm reinvests 11.5 − 3.1 − 0.8 = $7.6
million in new projects. With a return on new investmnet of 23.9%, this
means the firm generates $1.8164 in new earnings for year 2. Total earnings
in year 2 are thus $11.5 + $1.8164 = $13.3164.
Repeat the above to find the earnings for t = 2. If earnings at t = 2 are
$13.3164 with dividends of $2.0 and repurchases of $3.1, then the firm rein-
vests $8.2164 million in new projects. With a return on new investmnet of
13.0%, this means the firm generates $1.0681 in new earnings for year 3.
Total earnings in year 3 are thus $13.3164 + $1.0681 = $14.3845.
Finally, apply the constant growth perpetuity equation. The firm has earnings
of $14.3845 and pays out a total of $10.2 million. If it reinvests the remain-
der, its reinvestment rate is 14.3845−10.2
14.3845
= 0.2909. Multiply this by the return
on new investment of 5.4% to get the growth rate, g = 0.2909 × 0.054 =
0.015709. Therefore, the time t = 2 price of dividends beginning in year 3 is
Div + Repurchase 1.7 + 8.5
P2 = = = 116.85
ke − g 0.103 − 0.015709

Discount all payouts to get the answer:

Div1 + Repurchase1 Div2 + Repurchase2 + P2

P rice = +
1 + ke (1 + ke )2
3.1 + 0.8 2.0 + 3.1 + 116.85
= +
1.103 1.1032
= 103.77

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6. You believe that some important economic news is about to be released that
will change the yields on Australian government bonds. You are evaluating
three bonds, planning to buy them now (2016 ) and sell them shortly after
the news release (in a few minutes). Bonds A and B make annual coupon
payments; bond C is a zero-coupon bond. The information on the bonds is
listed below:

Bond Current Price Maturity Coupon Rate Face Value

A $1,035.37 2017 8.3% $1000
B 1,134.84 2018 15.0% 1000
C 759.57 2019 0.0% 1000

After the news is released, you expect the government bond yield curve to
have a 1 year rate of 2.73% APR, a 2 year rate of 5.03% APR, and a 3-year
rate of 8.77% APR. How should you prioritize these bonds for investment
if you have a limited budget? List the best option first, the second-best
second, and worst option last.

Answer: B, then C, then A

Compute the expected price each bond using the expected yield curve. You
are given the yield curve, which lists the discount rate for each individual
payment. This is not the yield to maturity, which gives a single discount
rate to use for all the bond payments. Therefore, the prices are

1083
Expected P riceA = = 1054.22
1.0273
150 1150
Expected P riceB = + = 1188.50
1.0273 1.05032
1000
Expected P riceC = = 777.09
1.08773

Now compute the profitability index of each bond. This is the expected price
over the current price

1054.22
P IA = = 1.0182
1035.37
1188.50
P IB = = 1.0473
1134.84
777.09
P IC = = 1.0231
759.57

Therefore, bond B is the best investment, followed by bond C, followed by

bond A.

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