Suppose that 5-year government bonds are selling on a ...



Suppose that 5-year government bonds are selling on a yield of 4 percent. Value a 5-year bond with a 6 percent coupon. Start by assuming that the bond is issued by a continental European government and makes annual coupon payments. Then rework your answer assuming that the bond is issued by the U.S. Treasury, so that the bond pays semiannual coupons and the yield refers to a semiannually compounded rate.

With annual coupon payments:

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With semi-annual coupon payments:

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Refer to the question above. How would the bond value in each case change if interest rates fall to 3 percent.

With annual coupon payments:

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With semi-annual coupon payments:

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In March 2004, Fly Paper’s stock sold for about $73. Security analysts were forecasting a long-term earning growth rate of 8.5 percent. The company is expected to pay a dividend of $1.68 per share. a. Assume dividends are expected to grow along with earnings at g = 8.5 percent per year perpetuity. What rate of return r were investors expecting? b. Fly Paper was expected to earn about 12 percent on book equity and to pay out about 50 percent of earnings as dividends. What do these forecasts imply for g? For r? Use the perpetual-growth DCF formula.

a. Using the growing perpetuity formula, we have:

P0 = Div1/(r – g)

73 = 1.68/(r - 0.085)

r = 0.108 = 10.8%

b. We know that:

Plowback ratio = 1.0 – payout ratio = 1.0 – 0.5 = 0.5

And, we also know that:

dividend growth rate = g = plowback ratio ( ROE

g = 0.5 ( 0.12 = 0.06 = 6.0%

Using this estimate of g, we have:

P0 = Div1/(r – g)

73 = 1.68/(r – 0.06)

r = 0.0830 = 8.30%

Consider the following three stocks: a. Stock A is expected to provide a dividend of $10 a share forever. b. Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 4 percent a year forever. c. Stock C is expect to pay a dividend of $5 next year. Therefore, dividend growth is expected to be 20 percent for 5 years (.e, until years 6) and zero therefore. If the market capitalization rate for each stock is 10 percent, which stock is the most valuable? What if the capitalization rate is 7 percent

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At a capitalization rate of 10 percent, Stock C is the most valuable.

For a capitalization rate of 7 percent, the calculations are similar.

The results are:

PA = $142.86

PB = $166.67

PC = $156.48

Therefore, Stock B is the most valuable.

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