THE UNIVERSITY OF HONG KONG

The School of Economics and Finance
FINA1310HIJ – Corporate Finance
2nd SEMESTER, 2017-2018
Tutorial 4 – Solutions

Question 1 (Price-Yield Relationship)

Bond P: P0 = $120(PVA9%,5) + $1,000(PV9%,5) = $1,116.69

P1 = $120(PVA9%,4) + $1,000(PV9%,4) = $1,097.19

Current yield = $120 / $1,116.69 = 10.75%

Capital gains yield = (New price – Original price) / Original price

Capital gains yield = ($1,097.19 – $1,111.69) / $1,116.69 = –1.75%

Bond D: P0 = $60(PVA9%,5) + $1,000(PV9%,5) = $883.31

P1 = $60(PVA9%,4) + $1,000(PV9%,4) = $902.81

Current yield = $60 / $883.81 = 6.79%

Capital gains yield = ($902.81 – 883.31) / $883.31 = 2.21%

All else held constant, premium bonds pay high current income while having price
depreciation as maturity nears; discount bonds do not pay high current income but
have price appreciation as maturity nears. For either bond, the total return is still 9%,
but this return is distributed differently between current income and capital gains.

Question 2 (Inflation, Real and Nominal Interest Rate of Return)

(a) R = r + h
Approximate r = 0.064 – 0.044 = 0.020

Using Fisher Equation:

(1 + R) = (1 + r)(1 + h)
(1 + 0.064) = (1 + r)(1 + 0.044)
Exact r = [(1 + 0.064) / (1 + 0.044)] – 1 = 0.0192
(b) R = (1 + 0.034)(1 + 0.025) – 1 = 0.0599

 
  

Question 3 (Zero Coupon Bonds)

(a) The coupon bonds have a 7% coupon which matches the 7% required return, so
they will sell at par. The number of bonds that must be sold is the amount needed
divided by the bond price, so:

Number of coupon bonds to sell = €15,000,000 / €1,000 = 15,000

The number of zero coupon bonds to sell would be:

Price of zero coupon bonds = €1,000/1.0730 = €131.37

Number of zero coupon bonds to sell = €15,000,000 / €131.37 = 114,181

(b) The repayment of the coupon bond will be the par value plus the last coupon
payment times the number of bonds issued. So:

Coupon bonds repayment = 15,000(€1,070) = €16,050,000

The repayment of the zero coupon bond will be the par value times the number of
bonds issued, so:

Zeroes: repayment = 114,181(€1,000) = €114,181,000

Question 4 (Stock Valuation)

The price of stock in Year 6 using Constant Growth Model:

The price of stock in Year 3 is the PV of dividends in Year 4, 5 and 6 plus PV of the
stock in Year 6:

The price of the stock in Year 0 is the PV of dividends in Year 1, 2 and 3 plus PV of
the stock in Year 3:

 
  

Question 5 (Non-constant Growth)

The price of the stock in Year 9:

The price of the stock today is simply the PV of the stock price in the future:

Question 6 (Supernormal Growth)

The stock begins constant growth in Year 4, so we can find the price of the stock at
Year 3, one year before the constant dividends growth begins:

The price of the stock today is the PV of the first three dividends plus the PV of the
stock price at Year 3:

Question 7 (Supernormal Growth)

D3 = D0(1.30)3
D4 = D0(1.30)3(1.18)

Stocks begins the constant growth in Year 4, so we can find the price of the stock in
Year 4 as the dividend in Year 5, divided by the required return minus the growth
rate:

Now we can substitute the previous dividend in Year 4 into the equation:

The stock price today is the PV of the dividends in Year 1, 2, 3, and 4, plus the PV of
the Year 4 price:

This is the dividend today, so the projected dividend will be:

 
  

Question 8 (Valuing Preferred Stock)

We know the dividend payment in Year 6, so we can find the stock price at Year 5,
one year before the first dividend payment:
P0 = D1 / r; P5 = D6 / r; P5 = NGN810 / 0.07 = NGN11,571.42

Price of the stock price today is the PV of the stock price in the future:
P0 = NGN11,571.42 / 1.075 = NGN8,250.27