Australian School Of Business

FINS1613: Business Finance

Tutorial Quiz
Practice Questions: Bonds & Equities

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Bonds

1. Removalists of Junk Inc. is issuing a new fifteen-year bond with a coupon

rate of 5.9%. Coupons are semi-annual. The risk-free yield to maturity on
similar term bonds trading in the market is 6.9% and Removalists of Junk
has a credit spread of 2.3%. The yield to maturity on Removalists of Junks
bonds is and the bond will trade at .

(a) 6.9%, par

(b) 9.20%, a discount (less than par)
(c) 9.20%, a premium (greater than par)
(d) 4.60%, a discount (less than par)
(e) 4.60%, a premium (greater than par)

Answer: b

The yield to maturity on a risky bond is the risk-free yield plus the credit
spread, 6.9% + 2.3% = 9.2%. Since the coupon rate, 5.9%, is less than the
yield to maturity, the bond trades at a discount.

2. The zero coupon bond yield curve shows that the one-, two-, and three-year
interest rates are 4.0%, 5.9%, and 7.6%, respectively. What is the price of
a three-year bond with a face value of $600 and coupons of 15% paid
annually?

(a) $648.42
(b) $720.67
(c) $481.63
(d) $643.01
(e) $715.25

Answer: b
The coupon payments will be $90 per year (15% of the face value of $600).
Therefore, the bond will pay $90 at t = 1, $90 at t = 2 and $690 at t = 3.
Discount each of these at the respective discount rates on the yield curve to
find the bond price:

Coupon Coupon Coupon + F ace V alue

P rice = + 2
+
1 + r1 (1 + r2 ) (1 + r3 )3
90 90 690
= + 2
+
1.04 1.059 1.0763
= 720.67

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3. Suppose a seven year, $1,000 bond with semi-annual coupons has a price of
$1,202.92 and a yield to maturity of 10% APR. What is the bonds coupon
rate?

(a) 12.2%
(b) 13.5%
(c) 10.4%
(d) 11.3%
(e) 14.1%

Answer: e

The bond pays semi-annually for seven years making n = 14 payments in

total. The semi-annual rate yield, y = 10%/2 = 5%. Using the bond pricing
equation (based on the annuity formula) means that:

F ace value
P rice = CP N Annuity F actor(y discount rate, n periods) +
(1 + y)n

where CPN is the semi-annual coupon payment. The annuity factor from
the tables is 9.8986. Plugging in to the equation above:
1000
1202.92 = CP N 9.8986 +
(1.05)14

Solving, CP N = $70.5. The annual coupon is twice the semi-annual coupon,

$141. The coupon rate is the annual coupon as a percent of face value,
141/1000 = 14.1%.

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4. Removalists of Junk Inc. is issuing a new eleven-year bond at a face value of
$1,000 with a coupon rate of 8.5%. Coupons are semi-annual. The risk-free
yield to maturity on similar term bonds trading in the market is 4% and
Removalists of Junk has a credit spread of 12%. What should be the price
of Removalists of Junks bond?

(a) $1,394.22
(b) $617.47
(c) $646.39
(d) $792.18
(e) $683.62

Answer: b
The bond pricing equation using yield to maturity is
 
1 1 F ace V alue
P rice = Coupon 1 +
y (1 + r)n (1 + r)n

To find each input:

n: Since this is an 11 year bond with semi-annual payments, it will

make 22 payments.
y: If the risk-free rate is 4% and firm has a credit spread of 12%, then
the YTM on the bonds is 16%. This is an APR, to get the (semi-annual)
period rate divide by 2. y = 0.08
Coupon: The coupon payments are found by multiplying the coupon
rate by the face value and dividing by 2 (for semi-annual payments).
Therefore, Coupon payments are $42.50 every six months.

The annuity factor for r = 0.08 and n = 22 is 10.2007. Substituting into

the pricing equation gives:

F ace V alue
P rice = Coupon 10.2007 +
(1 + r)n
1000
= 42.50 10.2007 +
1.082 2
= 617.47

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5. The short-term (overnight) interest rate is currently 5%. Assume the follow-
ing:

i. The reserve bank of Australia adjusts interest rates in order to slow a

rapidly expanding economy;
ii. Investors expect that interest rates will decrease in the future; and
iii. Interest rates reflect typical investor concerns about the high level of
price sensitivity to interest rate movements in long-term bonds.

Which of the following yield curves reflects all the assumptions above?

(a) (b)
10 10
Yield (%)

Yield (%)
5 5

0 0
0 2 4 6 8 10 0 2 4 6 8 10

Maturity (Years) Maturity (Years)

(c) (d)
10 10
Yield (%)

Yield (%)

5 5

0 0
0 2 4 6 8 10 0 2 4 6 8 10

Maturity (Years) Maturity (Years)

(e)
10
Yield (%)

0
0 2 4 6 8 10

Maturity (Years)

Answer: b

The Reserve Bank adjusts interest rates to slow a rapidly expanding econ-
omy by increasing the short-term interest rate. Therefore, the short-term
rate must increase and be greater than 5%. Then, if interest rates are ex-
pected to decrease, yield to maturity on short-term bonds will be less than
5%. Finally, investors generally demand higher yields on long-term bonds.
So, the yield curve must start above 5%. Then, it decreases for medium-term
bonds and increases for long-term bonds.

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 Equity

6. A company expects to have earnings in fiscal year 2014 of $52.30 when it

will payout 59% of earnings. The firm reinvests retained earnings in new
projects with an expected return on investment of 8% per year. What is the
expected dividend for fiscal year 2015 if it pays out 45% of earnings in that
fiscal year?

(a) $27.45
(b) $24.31
(c) $24.83
(d) $13.89
(e) $23.36

Answer: b

The growth rate in earnings, g, from 2014 to 2015 is equal to the expected
return on investment multiplied by the retention rate. If the firm pays out
59% of earnings, it holds on to 41% of earnings. Therefore, the growth rate
is

g = Retention Return on new investment

= 0.41 0.08
= .0328

This means earnings for the 2015 fiscal year is EPS in 2014 with 3.28%
growth: EP S2015 = EP S2014 (1 + g) = 52.30 1.0328 = $54.01544. If the
firm pays out 45% of earnings in 2015, then the dividend in 2015 is

Div2015 = EP S2015 P ayout2015 = 54.01544 0.45 = 24.306948 24.31.

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7. Prescott Pharmaceuticals will pay an annual dividend of $1.50 one year from
now. Analysts expect this dividend to grow at 18.6% per year thereafter until
the end of year twelve. After then, growth will level off at 4.0% per year.
According to the dividend-discount model, what is the value of a Prescott
Pharmaceuticals share if the firms equity cost of capital is 11.0%?

(a) $50.97
(b) $43.62
(c) $58.06
(d) $65.56
(e) $72.62

Answer: d

The dividend payments consist of a twelve year growing annuity and a grow-
ing perpetuity making the first payment in year 13. The value of the annuity
is given by:
  n 
1 1+g
Growing Annuity V aluet=0 = Ct=1 1
rg 1+r
"  1 #
1 1.186
= 1.50 1 2
.11 .186 1.11
= 23.96

Valuing the perpetuity requires determining the dividend in year 13. If the
year 1 dividend grows by 18.6% each year until year 12, then it grows over 11
years. So, Div12 = Div1 1.18611 = 1.5 1.18611 = 9.7954. The dividend in
year 13 is the year 12 dividend after growing by 4%, Div13 = Div12 1.04 =
10.1872. The growing perpetuity gives the value of the perpetuity as of year
12.
Div1 3 10.1872
P epetuity V aluet=12 = = = 145.5314
r gterminal .11 .04
The present value of the perpetuity is found by discounting the value above
twelve years to t = 0.
P erpetuity V aluet=12 145.5314
P erpetuity V aluet=0 = = = 41.60
(1 + r)12 1.1112

The total price of the stock is

P rice = Growing Annuity V aluet=0 + P erpetuity V aluet=0

= 23.96 + 41.60
= 65.56

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8. In one years time, a firm is expected to have earnings of $90 million. The
firm is expected to pay dividends of $35.5 million and spend $11.6 million on
share repurchases. Earnings are expect to grow by 16.7% annual fifteen times
(until t=16 ). After this period, earnings are expected to remain constant in
perpetuity. The firms cost of equity capital is 12.8% and the dividend and
repurchase rates are expected to stay constant in perpetuity. What is the
market value of the firms equity?

(a) $1,370.78 million

(b) $1,550.16 million
(c) $1,335.10 million
(d) $1,415.86 million
(e) $1,513.89 million

Answer: d
Use a total payout, 2-stage growth model. This consists of a growing annuity
from t = 1 to t = 16 and a constant perpetuity with first payment at t =
17. The total payout in one years time is the total of the dividends and
repurchases, 35.5 + 11.6 = $47.1million. If earnings grow at 16.7% and the
payout rates stay constant, then the growth in payouts will be 16.7%. The
first 16 years of payouts can be priced using a constant growth annuity model.
To find the terminal value of the constant perpetuity, first get the cash flow
at t = 17. The t = 1 payout will grow 15 times to t = 16. Therefore, the
total payout at t = 16 is 47.1 1.16715 = 477.62. This will be the same at
t = 17, so P ayout17 = 557.38. Now use a 2-stage growth model

M V Equity = Growing Annuity + P erpetuity with f irst payment at t = 17

 16 !
1 1+g 1 P ayout17
= P ayout1 1 +
rg 1+r (1 + r)16 r
 16 !
1 1.167 1 477.62
= 47.1 1 +
0.128 0.167 1.128 (1.128)16 0.128
= 872.70 + 543.16
= 1415.86

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9. Soylent Corp expects earnings this year (at t=1 ) of $6.14 per share. It
currently has a share price of $49.93. The firm pays 33% of earnings in
dividends and reinvests 67% of earnings in new projects. Reinvested earnings
provide a return on new investment of 13.7%. However, due to a disappearing
customer base, Soylent Corp will soon announce that the firm will begin
paying out 61% of all earnings as dividends, retaining 39% for investment
in new projects. What will be the share price after this announcement?
Investors are not expecting the firm to change its payout policy.

(a) $49.93
(b) $47.45
(c) $43.87
(d) $42.18
(e) $45.60

Answer: b
If the current dividend rate is 33% and the firm is expected to have earnings
of $6.14, then the expected dividend is 0.33 6.14 = 2.0262. If the current
reinvestment rate is 67% and the return on new investment is 13.7%, then
the current growth rate in earnings is g = 0.67 0.137 = 0.09179. Use the
current price to find the cost of equity rE :

Div1 2.0262
P = 49.93 =
rE g rE 0.09179
Solving gives rE = 0.132371. At the new dividend rate, the expected dividend
this year will be 0.61 6.14 = 3.7454. At the new retention rate of 39%, the
firms growth in earnings will drop to 0.39 0.137 = 0.05343. Substituting
into the pricing equation gives the new share price

3.7454
Pnew = = 47.45
0.132371 0.05343

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