Business Finance (Section E)

Assignment – Bond Valuation, Stock Valuation and Capital Budgeting Techniques

Submission – May 19, 2012

Bonds Valuation

1. A bond trader purchased each of the following bonds at a yield to maturity of 8 percent. Immediately after she purchased the bonds interest rates fell to 7 percent.

a. What is the percentage change in the price of each bond after the decline in interest rates? Fill in the following table:

PRICE @ 8% PRICE @ 7% PERCENTAGE CHANGE

10-year, 10% annual coupon _____________________ ______________________ _____________________

10-year zero _____________________ _____________________ _____________________

5-year zero _____________________ _____________________ _____________________

30-year zero _____________________ _____________________ _____________________

$100 perpetuity _____________________ _____________________ ____________________

b. Can you draw a conclusion about interest rate sensitivity of bonds of different maturity from above calculations?

2. An investor has two bonds in his portfolio. Each bond matures in 4 years, has a face value of $1,000, and has a yield to maturity equal to 9.6 percent. One bond, Bond C, pays an annual coupon of 10 percent; the other bond, Bond Z, is a zero coupon bond.

a) Assuming that the yield to maturity of each bond remains at 9.6 percent over the next 4 years, what will be the price of each of the bonds at the following time periods? Fill in the following table:

T PRICE OF BOND C PRICE OF BOND Z

0 _____________________ _____________________

1 _____________________ _____________________

2 _____________________ _____________________

3 _____________________ _____________________

4 _____________________ _____________________

b) Plot the time path of the prices for each of the two bonds. Can you draw a conclusion?

Stock Valuation

1. Harrison Clothiers’ stock currently sells for $20 a share. The stock just paid a dividend of $1.00 a share (i.e., D0 _ $1.00). The dividend is expected to grow at a constant rate of 10 percent a year. What stock price is expected 1 year from now? What is the required rate of return on the company’s stock?

2. Martell Mining Company’s ore reserves are being depleted, so its sales are falling. Also, its pit is getting deeper each year, so its costs are rising. As a result, the company’s earnings and dividends are declining at the constant rate of 5 percent per year. If D0 _ $5 and ks _ 15%, what is the value of Martell Mining’s stock?

3. Microtech Corporation is expanding rapidly, and it currently needs to retain all of its earnings, hence it does not pay any dividends. However, investors expect Microtech to begin paying dividends, with the first dividend of $1.00 coming 3 years from today. The dividend should grow rapidly—at a rate of 50 percent per year—during Years 4 and 5. After Year 5, the company should grow at a constant rate of 8 percent per year. If the required return on the stock is 15 percent, what is the value of the stock today?

4. Investors require a 15 percent rate of return on Levine Company’s stock (ks _ 15%).a. What will be Levine’s stock value if the previous dividend was D0 _ $2 and if investors

expect dividends to grow at a constant compound annual rate of (1) _5 percent, (2) 0 percent, (3) 5 percent, and (4) 10 percent?

b. Using data from part a, what is the Gordon (constant growth) model value for Levine’s stock if the required rate of return is 15 percent and the expected growth rate is (1) 15 percent or (2) 20 percent?

c. Is it reasonable to expect that a constant growth stock would have g >k? Explain.

Capital Budgeting

1. After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation must decide whether to mine the deposit. The most cost-effective method of mining gold is sulfuric acid extraction, a process that results in environmental damage. To go ahead with the extraction, CTC must spend $900,000 for new mining equipment and pay $165,000 for its installation. The gold mined will net the firm an estimated $350,000 each year over the 5-year life of the vein. CTC’s cost of capital is 14 percent. For the purposes of this problem, assume that the cash inflows occur at the end of the year.

a. What is the NPV and IRR of this project?b. Should this project be undertaken, ignoring environmental concerns?c. How should environmental effects be considered when evaluating this, or any other, project? How might these effects change your decision in part b?

2. A firm with a required return of 10% is considering following mutually exclusive projects

Year Project A Project B0 (400) (600)1 55 3002 55 3003 55 504 225 505 225 50

a. According to the payback criterion, which project should be accepted?b. According to the discounted payback criterion, which project should be

accepted?c. According to the NPV criterion, which project should be accepted?d. According to the IRR criterion, which project should be accepted?

3. Under what conditions IRR rule breaks down?

4. Justin is evaluating a project that is expected to produce cash flows of 7,500$ each year for the next 10 years and $10,000 each year for the following 10 years. The IRR for this 20 year project is 10.98%. If the required return is 9 percent, what is the project’s NPV?