Solutions to Problems Set A

6-1A. krf = .045 + .073 + (.045 x .073) krf = .1213 or 12.13% = nominal rate of interest 6-2A. krf = .064 + .038 + (.064 x .038) krf = .1044 or 10.44% = nominal rate of interest

6-3A. (A) Probability P(ki) .15 .30 .40 .15 (B) Return (ki) -1% 2 3 8 (A) x (B) Expected Return k -.15% 0.60% 1.20% 1.20% 2.85% Weighted Deviation (ki - k )2P(ki) 2.223% 0.217% 0.009% 3.978% 6.427% 2.535%

k=

= =

No, Pritchard should not invest in the security. The level of risk is excessive for a return which is less than the rate offered on treasury bills. 6-4A. Common Stock A: (A) Probability P(ki) 0.3 0.4 0.3 (B) Return (ki) 11% 15 19 (A) x (B) Expected Return k 3.3% 6.0 5.7 15.0% Weighted Deviation (ki - k )2P(ki) 4.8% 0.0 4.8 9.6% 3.10%

k =
Required 6-9A.` Rate of Return Risk-Free Rate

2 = =

= = =

(Market Return - Risk-Free Rate) X Beta

7.5% + (11.5% - 7.5%) x 0.765 10.56% Zemin kb (kb - k )2 6.00% 3.00 1.00 -3.00 5.00 0.00 12.00 16.00% 1.00 1.00 25.00 9.00 4.00 56.00 Market kb (kb - k )2 4.00% 2.00 -1.00 -2.00 2.00 2.00 7.00 8.03% 0.69 4.69 10.03 0.69 0.69 24.82

6-12A.a. Month 1 2 3 4 5 6 Sum

Average monthly return (Sum 6) Annualized average returns Variance (Sum 5) Standard deviation b. Required Rate of Return = = c.

2.00%

1.17%

24.00% 11.20%

14.04% 4.97%

3.35%

2.23%

Risk-Free + (Market Return - Risk-Free Rate) X Beta Rate 8% + [(14% - 8%) X 1.54] = 17.24%

Zemin's historical return of 24 percent exceeds what we would consider a fair return of 17.24 percent, given the stock's systematic risk.

Solutions to Problem Set B

7-1B. Value (Vb) =

t 1

10

$90 (1 .15)
t

$1,000 (1 .15)10

10 15 90 1000

N I/Y PMT FV PV ANSWER -698.87

CPT

7-2B. If the interest is paid semiannually: Value (Vb) =

t 1

22

$50 (1.045)
t

$1,000 (1.045)22

22 4.5 50 1000

N I/Y PMT FV PV ANSWER -1068.92

CPT

If interest is paid annually: Value (Vb) =

t 1

11

$100 (1.09)t

$1,000 (1.09)11

11 9 100 1000

N I/Y PMT FV PV ANSWER -1068.05

CPT

7-3B. $950 =

t 1

16

$45 (1 k b /2)
N +/PMT FV I/Y PV
t

$1,000 (1 k b /2)16

16 950 45 1000

CPT

ANSWER

4.96%

The rate is equivalent to 9.92 percent annual rate, compounded semiannually or 10.17 percent (1.04962 - 1) compounded annually. 7-4B. $975 =

t 1

20

$100 (1 k b ) t
N +/PMT FV I/Y PV

$1,000 (1 k b )20

20 975 100 1000

CPT
7-5B. $1,175 =

ANSWER
$1,000 (1 k b )15

10.30%

t 1

15

$80 (1 k b ) t

15 1175 80 1000

N +/PMT FV I/Y ANSWER 6.18% PV

CPT

7-6B. a.

$1,100 =

t 1

14

$90 (1 k b ) t

$1,000 (1 k b )14

14 1100 90 1000

N +/PMT FV I/Y ANSWER 7.80% PV

CPT
b. Vb =

t 1

14

$90 (1.10)t

$1,000 (1.10)14

14 10 90 1000

N I/Y PMT FV PV ANSWER -926.33

CPT
c.

Since the expected rate of return, 7.80 percent, is less than your required rate of return of 10 percent, the bond is not an acceptable investment. This fact is also evident because the market price, $1,100, exceeds the value of the security to the investor of $926.33.

7-7B. a. Value Par Value Coupon Required Rate of Return Years to Maturity Market Value Value at Alternative Rates of Return Required Rate of Return Market Value Required Rate of Return Market Value $1,000.00 $ 80.00 7% 20 $ 1,105.94

b.

10% $ 829.73 6% $1,229.40

c.

As required rates of return change, the price of the bond changes, which is the result of "interest-rate risk." Thus, the greater the investor's required rate of return, the greater will be his/her discount on the bond. Conversely, the less his/her required rate of return is below that of the coupon rate, the greater the premium will be. Value at Alternative Maturity Dates Years to Maturity Required Rate of Return Market Value Required Rate of Return Market Value 10 10% $ 877.11 6% $1,147.20

d.

e.

The longer the maturity of the bond, the greater the interest-rate risk the investor is exposed to, resulting in greater premiums and discounts. Value (Vb) =

7-9B. (a)

t 1

17

$70 $1,000 + 17 (1 .085) (1 .085 )17

17 8.5 70 1000

N I/Y PMT FV PV ANSWER -867.62

CPT

(b)

(i)

Value (Vb)

17

t 1

$70 $1,000 + 17 (1 .11) (1 .11)17

17 11 70 1000

N I/Y PMT FV PV ANSWER -698.05

CPT

(b)

(ii)

Value (Vb)

t 1

17

$70 $1,000 + 17 (1 .06) (1 .06 )17

17 6 70 1000

N I/Y PMT FV PV ANSWER -1,104.77

CPT
(c) 7-11B.

We see that value is inversely related to the investor's required rate of return. a.$1,350 = 4 N +/PMT FV I/Y Vb = 4 9 120
$120 (1.09) t

t 1

$120 (1 k b ) t

$1,000 (1 k b ) 4

1350 120 1000

PV

CPT
b.

ANSWER
$1,000 (1.09) 4

2.66%

t 1

N I/Y PMT

1000

FV PV ANSWER -1,097.19

CPT
c.

Since the expected rate of return, 2.66 percent is much less than your required rate of return of 9 percent, the bond is not an acceptable investment. This fact is also evident because the market price, $1,350, exceeds the value of the security to the investor of $1,097.19. $915 25 915 80 1000 = N +/PMT FV I/Y ANSWER 8.86% PV

7-12B. a.

t 1

25

$80 (1 k b ) t

$1,000 (1 k b ) 25

CPT

b. Since the required rate of return(11%) is greater than the expected rate of return(8.86%), you should not purchase the bond.