Test Bank Chapter 5: Valuing Bonds and Stocks EFS

I. True or False (Definitions and Concepts)

T 1. A bond is a long-term obligation for borrowed money.

F 2. A bond debenture is the contract detailing the terms of a bond.

(FALSE: Should be indenture instead of debenture.)

T 3. A call provision gives the issuer the right to pay off the bonds prior to their
maturity by paying a call price.

F 4. The market price of a bond in today’s dollars is the future value of its promised
future coupon and principal payments.
(FALSE: Should be present value instead of future value.)

T 5. The current yield for a bond equals its annual coupon payment divided by its
closing price.

F 6. Because a change in the required return causes a change in a bond's market price,
possessing a bond is not a risky undertaking.
(FALSE: Should be is a risky instead of not a risky.)

F 7. A balloon provision gives the firms an option of calling the bond before its
maturity by buying the bond back.
(FALSE: Should be call instead of balloon.)

T 8. A zero coupon bond (or pure discount bond) pays only a terminal value.

T 9. Common stockholders are the residual owners of the firm.

F 10. Common stock payment obligations are typically viewed like debt obligations.
(FALSE: Should be preferred instead of common.)

T 11. Earnings can be paid out in dividends or retained by the firm to finance ongoing
productive activities.

F 12. A high payout ratio emphasizes income at the expense of growth since a higher
rate of dividend payout indicates more retained earnings for growth.
(FALSE: Should be less retained earnings instead of more retained earnings.)

D1
T 13. The expression for a stock’s price, given as P0 = , is the value of a
r-g
perpetuity growing at a constant rate (g).

T 14. A stock’s required rate of return is often called a capitalization rate.

T 15. A high P (which is often deemed good) can also result from a bad year.
E
II. Multiple Choice (Definitions and Concepts)

b 16. Common stockholders are the owners of the firm. Which of the following is true?
a. Stockholders do not elect the firm's directors
b. If the firm is liquidated, the stockholders share proportionately after the claimants
with higher legal priority are paid.
c. In terms of claims, common stockholders rank ahead of preferred stockholders
but below bondholders.
d. b&c

d 17. Which of the following statements (if any) are false?

D1
a. The Dividend Valuation Model with constant growth implies that r = + g.
P0
D1 D
b. The income component of the equation, r = + g, is 1 and is called the
P0 P0
dividend yield. It can be found in financial publications such as the Wall Street Journal.
D
c. The capital gains component of the equation, r = 1 + g, is g and is called the
P0
capital gains yield. It is estimated by financial sources such as the Value Line Investment Survey.
d. none of these

a 18. Preferred stock payment obligations are typically .

a. viewed like debt obligations.
b. issued with a maturity date.
c. valued as an annuity.
d. none of these

c 19. The price of common stock (Pn) can be expressed as the present value of the
expected annual future dividends plus the present value of the expected future sale price of a
D1 D2 Dn Pn
share of stock at time n. We have: P0 = 1 + 2 +...+ n + . Which of
( 1+r ) ( 1+r ) ( 1+r ) ( 1+r ) n
the following is true?
a. For this calculation, we consider taxes.
b. For this calculation, we consider the quarterly payment of dividends.
c. The change in price from P0 to Pn is called the capital gain or loss.
d. b&c

a 20. If the yield to maturity for a bond is less than the bond's coupon rate, then the
market value of the bond is .
a. greater than the par value.
b. less than the par value.
c. equal to the par value.
d. cannot tell

a 21. The return expected by equity investors is called the .

a. market capitalization rate.
b. dividend yield.
c. average cost of capital.
d. none of these
d 22. Growth in earnings depends on the amount of money retained and earned on that
which is retained. Which of the following is (are) true?
a. The proportion of money retained is the retention rate, which is (1 − POR).
b. An estimate of g can be obtained by multiplying the retention rate times the
expected return on the retained and reinvested money.
c. The proportion of money retained is the retention rate, which is (POR − 1).
d. a&b

d 23. Assume that the par value of a bond is $1,000. Consider a bond where the
coupon rate is 9% and the current yield is 10%. Which of the following statements is true?
a. The current yield was a lot less than 9% when the bond was first issued
b. The current yield was a lot greater than 9% when the bond was first issued
c. The market value of the bond is more than $1,000
d. The market value of the bond is less than $1,000

d 24. Bond data found in the financial pages typically include .

a. the coupon rate.
b. the year of maturity.
c. the current yield.
d. all of these

d 25. In many cases, preferred stock can be considered as a perpetuity. A perpetuity is

can be defined as .
a. a payment of a fixed amount for a finite period of time.
b. a series of payments of unequal amounts for each of a number of consecutive
periods.
c. a series of payments of equal amounts that occur at irregular intervals.
d. none of these

c 26. Which of the following assets would pay a dividend?

a. a U.S. Treasury security
b. a municipal bond
c. a share of preferred stock
d. corporate bond

a 27. Which of the following is not the responsibility of the bond’s trustees?
a. Decide when the bonds should be converted.
b. Make sure terms of the bond contract are followed.
c. Manage the bond provisions.
d. Monitor the protective covenants for the bondholders.

d 28. A bond indenture is the contract detailing the terms of a bond. At a minimum, the
typical bond indenture includes:
a. the par value (or face value) which is the amount of money (typically $1,000) the
issuer must repay by the end of the bond's life.
b. the coupon rate which determines the fixed payment promised by the company.
c. the maturity or length of the bond's life.
d. all of these
d 29. Which of the following items does not generally appear in a corporate bond
quote by the financial press?
a. current yield
b. maturity yield
c. coupon rate
d. yield-to-maturity

c 30. A bond indenture is the contract detailing the terms of a bond. At a minimum, the
typical bond indenture includes:
a. the par value which is the semi-annual interest payment.
b. when the bond will be called.
c. the maturity or length of the bond's life.
d. when the bond will be converted.

b 31. Which of the following statements is true?

a. A bond issue that requires the repayment of the entire principal amount at
maturity is said to have a balloon maturity.
b. When a bond issue is repaid in multiple installments, the method of repayment is
called a sinking fund.
c. When the final repayment of principal is larger than its par value then it is called
a bullet payment.
d. When the required return equals the coupon rate, the fair price equals the call
value.

a 32. Which of the following statements is true?

a. A bond issue that requires the repayment of the entire principal amount at
maturity is said to have a bullet maturity.
b. When a bond issue is repaid in multiple installments, the method of repayment is
called a coupon payment.
c. When the final repayment of principal is smaller than its par value then it is
called a balloon payment.
d. When the required return is greater than the coupon rate, the fair price equals the
par value.

d 33. Which of the following statements is false?

a. CPN is the coupon rate times the par value.
b. The bond's current required return is r which is an APR or nominal rate for a
year.
c. The current yield equals the annual coupon payment divided by the closing dollar
price.
d. The CPN is the APR that equates the bond's market price to the present value of
its promised future cash flows.

b 34. Which of the following statements is false?

a. CPN is the coupon rate times the par value.
b. The bond's current required return is r which is an APY rate for a year.
c. The current yield equals the annual coupon payment divided by the closing dollar
price.
d. The YTM is the APR that equates the bond's market price to the present value of
its promised future cash flows.
b 35. A bond's expected return is estimated by its YTM. Which of the following is
true?
a. The YTM is the APR that equates the bond's market price to the future value of
its promised cash flows.
b. Because most bonds pay semiannually, YTM equals 2 times the 6-month return
implied by the bond's market price.
c. The YTM considers the possibility that the firm might make late payments or
even default on its payments.
d. The APY for a bond is less than the YTM or APR since it considers semiannual

( )
2
compounding, e.g., APY = 1 + APR - 1 < APR.
2

a 36. A bond's expected return is estimated by its YTM. Which of the following is
false?
a. The YTM is the APY that equates the bond's market price to the present value of
its promised future cash flows.
b. Because most bonds pay semiannually, YTM equals 2 times the 6-month return
implied by the bond's market price.
c. The YTM ignores the possibility that the firm might make late payments or even
default on its payments.
d. The APY for a bond is greater than the YTM or APR since it considers

( )
2
semiannual compounding, e.g., APY = 1 + APR - 1 > APR.
2

a 37. Because a change in the required return causes a change in a bond's fair price,
owning a bond is risky even if the bond is otherwise healthy. This risk is called .
a. interest rate risk.
b. inflation risk.
c. market risk.
d. bond risk.

c 38. In the long-term, dividends paid to stockholders come from .

a. selling assets.
b. borrowing.
c. earnings.
d. none of these

d 39. In the short-run, dividends paid to stockholders can come from .

a. selling assets.
b. borrowing.
c. earnings.
d. all of these

d 40. Growth in dividends is:

a. positively related to dividend payout and return on invested assets.
b. negatively related to dividend payout and return on invested assets.
c. positively related to dividend payout and negatively related to return on invested
assets.
d. negatively related to dividend payout and positively related to return on invested
assets.
d 41. Growth in earnings per share can come from .
a. earnings retained.
b. selling stock.
c. borrowing.
d. all of these.

c 42. Two components of a stock’s return are .

a. coupon yield and capital gain yield.
b. interest yield and maturity yield.
c. dividend yield and capital gains yield.
d. dividend yield and maturity yield.

a 43. The value (P0) of a constant growth stock is .

D1
a. .
r-g
b. D1(r + g).
D1
c. .
r+g
d. D1(r − g).

b 44. When all else is equal, interest rate risk is greater with .
a. a longer original maturity.
b. a longer remaining maturity.
c. a shorter original maturity.
d. a shorter remaining maturity.

III. Multiple Choice (Problems)

a 45. Suppose you purchase a zero coupon bond for $214.55 with a face value of
$1,000 maturing in twenty years. If the yield to maturity (YTM) on the bond is 8.00%, what will
the price of the bond be at the end of five years from now?
a. $315.24
b. $387.52
c. $410.91
d. none of these
[ANSWER: We want to know the future value of the zero coupon bond in five years with YTM =
8% and current value (PV) = $214.55. We have: FVn = PV(1+r)n = $214.55(1.08)5 = $315.24.]

a 46. A bond for J. Morris, Inc. a coupon rate of 6%. The yield to maturity is 7%. The
bond has a remaining life of 20 years and makes semi-annual coupon payments? What is the
present value of the bond’s face value?
a. $252.57
b. $640.65
c. $893.22
d. $1,000.00
$1,000 $1,000
[ANSWER: Present value of the bond’s face value = 2n = ( ) =
( 1 + r / 2) ( 1 + 0.07 / 2 ) 2 20
$1,000[0.252572] = $252.572.]
d 47. A bond for Firebird, Inc. has a coupon rate of 7%. The yield to maturity is 6.8%.
The bond has a remaining life of 30 years and makes annual coupon payments? What is this
bond’s current market value?
a. $138.95
b. $886.37
c. $1,000.00
d. $1,025.32
[ANSWER: We use the bond valuation formula with annual coupon payments:
�( 1 + r ) n - 1 � $1,000
B0 = [CPN] � �+ n . Inserting in our values gives:
�( r) (1+ r) 2 � (1+ r)
� ( 1 + 0.068 ) 30 - 1 � $1,000
B0 = [$70] � 30 �+ 30 =
( 0.068 ) ( 1 + 0.068 ) � ( 1 + 0.068 )
�
[$70][12.662482] + $1,000[0.13895124] = $886.3737 + $138.9512 = $1,025.32.]

c 48. A bond for J. Morris, Inc. a coupon rate of 6%. The yield to maturity is 7%. The
bond has a remaining life of 20 years and makes semi-annual coupon payments? What is this
bond’s current market value?
a. $252.57
b. $640.65
c. $893.22
d. $1,000.00
[ANSWER: We use the bond valuation formula with semi-annual coupon payments:
�CPN ��( 1 + r / 2 ) 2 n - 1 � $1,000
B0 = 2 n �+ ( 2 n . Inserting in our values gives:
� 2 �� � ( r / 2) ( 1 + r / 2) � 1 + r / 2)

$60 � ( 1 + 0.07 / 2 ) 2( 20 ) - 1 � $1,000

�
B0 = � ��� �+
( ) 2( 20 ) =
2 � ( 0.07 / 2 ) ( 1 + 0.07 / 2 ) 2 20 � ( 1 + 0.07 / 2 )

[$30][21.355072] + $1,000[0.252572] = $640.652 + $252.572 = $893.22.]

c 49. A bond for Ballhawkers, Inc. has a coupon rate of 7%. The yield to maturity is
6.8%. The bond has a remaining life of 30 years and makes semi-annual coupon payments? What
is this bond’s current market value?
a. $890.941
b. $1,000.00
c. $1,025.46
d. $1,055.46
[ANSWER: We use the bond valuation formula with semi-annual coupon payments:
CPN ��( 1 + r / 2 ) - 1 �+ $1,000 . Inserting in our values gives:
2n
B0 = � � 2 �� � 2n
�( r / 2 ) ( 1 + r / 2 ) 2n � ( 1 + r / 2 )

$70 � ( 1 + 0.068 / 2 ) 2( 30 ) - 1 � $1,000

B0 = � �� �+
( ) 2( 30 ) =
�2 �� ( 0.068 / 2 ) ( 1 + 0.068/ 2 ) 2 30 � ( 1 + 0.068/ 2 )

[$35][25.455477] + $1,000[0.134514] = $890.941 + $134.514 = $1,025.46.]

a 50. Disney Corp. made a coupon payment yesterday on its "6.25s12" bonds that
mature on October 9, 2022. The required return on these bonds is 9.2% APR, and today is April
10, 2003. What should be the market price of these bonds?
a. $734.85
b. $651.76
c. $561.76
d. $173.09
[ANSWER: With a coupon rate of 6.25%, the annual coupon payment is $62.50; thus, the semi-
annual payment of CPN/2 = $62.50/2 = $31.25. The time to maturity (N) is 19.5 years. Thus, the
number of periods is 2N = 2(19.5) = 39 periods. The semi-annual APR is 9.2%/2 = 4.6% or
0.046. We use the bond valuation formula with semi-annual coupon payments:
� CPN ��( 1 + r / 2 ) 2 n - 1 � $1,000
B0 = 2 n �+ 2 n . Inserting in our values gives:
� 2 �� �( r / 2) ( 1 + r / 2) � ( 1 + r / 2)
2( 19.5 )
$62.50 �� ( 1 + 0.092 / 2 )
B0 = �
-1 � $1,000
� 2 �� (
( 0.092 / 2 ) ( 1 + 0.092 / 2 ) 2 19.5
�
) �+
� ( 1 + 0.092 / 2 )
2( 19.5 ) =

[$31.25][17.976371] + $1,000[0.173087] = 561.762 + 173.087 = $734.85.]

c 51. RCA made a coupon payment yesterday on its "6.25s12" bonds that mature on
October 9, 2012. The required return on these bonds is 9.2% APR, and today is April 10, 2003.
What should be the market price of these bonds?
a. $800.25
b. $807.77
c. $815.78
d. $819.77
[ANSWER: With a coupon rate of 6.25%, the annual coupon payment is $62.50; thus, the semi-
annual payment of CPN/2 = $62.50/2 = $31.25. The time to maturity (N) is 9.5 years. Thus, the
number of periods is 2N = 2(9.5) = 19 periods. The semi-annual APR is 9.2%/2 = 4.6% or 0.046.
We use the bond valuation formula with semi-annual coupon payments:
CPN �� ( 1 + r / 2 ) - 1 �+ $1,000 . Inserting in our values gives:
2n

B0 = �
� 2 � ( r / 2 ) ( 1 + r / 2 ) 2n � ( 1 + r / 2 ) 2n
�
� �
2( 9.5 )
$62.50 �� ( 1 + 0.092 / 2 )
B0 = �
-1 � $1,000
� 2 �( � 2( 9.5 )
�+ 2( 9.5 ) =
�0.092 / 2 ) ( 1 + 0.092 / 2 ) � ( 1 + 0.092 / 2 )
[$31.25][12.489164] + $1,000[0.425498] = $390.286 + $425.498 = $815.78.]

b 52. A bond for J. Morris, Inc. a coupon rate of 6%. The yield to maturity is 7%. The
bond has a remaining life of 20 years and makes semi-annual coupon payments? What is the
present value of the bond’s interest payments?
a. $252.57
b. $640.65
c. $893.22
d. $1,000.00
[ANSWER: Present value of the bond’s interest payments = PV(coupon payments) =
2( 20 )
CPN �� ( 1 + r / 2 ) - 1 �= � $60 �� ( 1 + 0.07 / 2 ) - 1 �=
2n
� �
� 2 �� 2n � ( ) �
( r / 2 ) ( 1 + r / 2 ) � �2 ��
� ( 0.07 / 2 ) ( 1 + 0.07 / 2 ) 2 20 �
[30][21.355072] = $640.65.]

a 53. You own a stock that will start paying $0.50 annually at the end of the year. It
will then grow each year at a constant annual rate of 5%. If the required rate of return is 14%,
what should you pay per share?
a. $5.56
b. $4.27
c. $3.57
d. $0.50
D1 $0.50 $0.50
[ANSWER: P0 = = = = $5.56.]
r-g 0.14 - 0.05 0.09

c 54. What is the present value of a zero coupon bond that will pay $1,000 in two years
if the applicable discount rate equals 8 percent?
a. $827.35
b. $847.34
c. $857.34
d. $1,000.00
FV 2 $1,000 $1,000
[ANSWER: PV = = = = $857.34.]
( 1 + r ) 2 ( 1.08 ) 2 1.1664

c 55. What should you pay for a stock assuming you expect the following: a dividend
of $1.00 paid at the end of years 1 and 2; cost of equity equal to 8 percent; and, a selling price of
$31 at the end of two years?
a. $1.79
b. $26.58
c. $28.36
d. $31.79
D1 D2 P2 $1 $1 $31
[ANSWER: P0 = 1 + 2 + 2  P0 = 1 + 2 + 2 
( 1+r ) ( 1+r ) ( 1+r ) ( 1.08 ) ( 1.08 ) ( 1.08 )
P0 = $0.9259 + $0.8573 + $26.5775 = $28.36.]

c 56. You have $500 that you would like to invest. You have two choices. Investment
#1 yields a return of 8% compounded annually while Investment #2 yields 7.75% compounded
monthly. Which would you choose and why?
a. Choose the 8% annual yield because it has a higher effective annual rate.
b. Choose the 7.75% monthly yield because it has a lower effective annual rate..
c. Choose the 7.75% monthly yield because it has a higher effective annual rate.
d. cannot tell
[ANSWER: We need to figure the APYs for the two investments noting that m is 12 for
Investment #2. Since Investment #1 is already an annual rate, its APY is the same as its APR of

( ) ( )
m 12
8.00%. For Investment #2, we have: APY = 1 + APR - 1 = 1 + 0.0775 -1 =
m 12

12 )
( 1 + 0.0775
12
- 1 = (1 + 0.00645833)12 − 1 = (1.00645833)12 − 1 = 1.080313 − 1 = 0.080313 or
about 8.03% effective yield or APY. Thus, we will choose the 7.75% compounded monthly yield
because it has the highest effect rate of return.]
b 57. Suppose Toyota has nonmaturing (perpetual) preferred stock outstanding that
pays a $2.00 quarterly dividend and has a required return of 12% APR (3% per quarter). What is
the stock worth?
a. $33.33
b. $66.67
c. $100.00
d. cannot tell
[ANSWER: For a perpetuity, the preferred stock value equals the perpetual dividend payment
divided by the required rate of return. Since the payments are quarterly, we use the quarterly
dividend payment and the quarterly rate of 3%. Thus, we have: P0 = D/r = $2/0.03 = $66.67.
NOTE. We get the same result using annual data, e.g., P0 = $8/0.12 = $66.67.]

c 58. Assume that IBM is expected to pay a total cash dividend of $5.60 next year and
that dividends are expected to grow at a rate of 5% per year forever. Assuming annual dividend
payments, what is the current market value of a share of IBM stock if the required return on IBM
common stock is 10%?
a. $140.00
b. $122.00
c. $112.00
d. none of these
[ANSWER: The dividend growth model asserts: P0 = D1 / (r − g) where D1 is next year's
dividend (e.g., $5.60 at t = 1), g is the growth rate in dividends per year forever (where g = 5%),
and r is the required rate of return on stock (where r = 0.1). We have: P0 = $5.60 / (0.10 − 0.05) =
$112.00..]

d 59. What is the YTM of a Coca-Cola bond that is currently selling for $782.50, has a
6% coupon rate, and matures in exactly 6 years?
a. 6.000%
b. 3.000%
c. 5.528%
d. 11.056%
[ANSWER: The inputs are B0 = 782.50, CPN/2 = 30.00 (one-half of 6.00% of $1000), and 2N =
12. The r/2 that solves this problem is 5.528%. Since r is the YTM, the YTM for this bond is two
times r/2 or 11.056%. CALC: N = 12; PV = −782.50; PMT = 30.00; FV = 1,000; I = 5.528.]

a 60. The bonds of Little John’s Inc. pay a 10% annual coupon, have a $1,000 face
value, and mature in fourteen years. Bonds of equal risk yield 7%. What should the market value
of Little John’s bonds be using annual payments?
a. $1,262.37
b. $1,268.37
c. $1,272.37
d. $1,278.37
[ANSWER: We use the bond valuation formula with annual coupon payments:
�( 1 + r ) n - 1 � $1,000
B0 = [CPN] � �+ n . Inserting in our values gives:
�( r) (1+ r) 2 � (1+ r)
� ( 1 + 0.07 ) 14 - 1 � $1,000
B0 = [$100] � 14 �+ 14 =
( 0.07 ) ( 1 + 0.07 ) � ( 1 + 0.07 )
�
[$100][ 8.745468] + $1,000[0.3878172] = $874.55 + $387.82 = $1,262.37.]
b 61. Suppose IBM has a bond that can’t be called today, but can be called in 3 years at
a call price of $1090. The bond has a remaining maturity of 18 years and a coupon rate of 12%. It
currently sells for $1175.97. What is the bond’s YTC? In other words, what return will be earned
from buying this bond today for $1175.97, if the firm makes all promised payments and redeems
the bonds in three years by paying $1090?
a. 7.950%
b. 8.000%
c. 8.050%
d. 8.100%
[ANSWER: For this problem, we use our calculator with the call price replacing the par value.
The inputs are B0 = 1175.97, CPN/2 is 60.00 (one-half of 12% of $1000), future value is 1090,
and 2N = 6 (since 3 years until the call). The r/2 that solves the equation is 4.000%. Therefore,
this bond’s YTC is 8.000%. CALC: N = 6; PV = −1,175.97; PMT = 60.00; FV = 1,090; I = 4.00.]

d 62. Consider the following bond: the current annual bond yield is 7%, the coupon
rate is 10%, interest is paid every 6 months, and the remaining maturity on the bond is 5 years.
What is the bond's current market value assuming semi-annual interest payments?
a. $1,024.75
b. $1,104.75
c. $1,024.75
d. none of these
[ANSWER: . Note that we have the following values for variables used in the bond formulas: r/2
= 7%/2 = 3.5% or 0.035, 2N = 2(5) = 10, and CPN/2 = (0.1)($1,000)/2 = $50. Using our bond
formula and inserting in our values, we get: B0 = PV(coupon payments) + PV(par value) =
$415.83 + $708.92 = $1,124.75.]

a 63. J.C. Penney has a zero-coupon bond that will pay $1000 at maturity on April 9,
2018, and today is April 9, 1998. The bond is selling for $178.43. What is its YTM?
a. 8.806%
b. 4.403%
c. 7.356%
d. 10.860%
[ANSWER: The inputs used are the same as a coupon paying bond except the input for PMT is
zero since zero-coupon bonds to pay out interest in cash but reinvests interest. The r/2 that solves
this problem is 4.403%, so the YTM is two times r/2 or 8.806%. CALC: N = 40; PV = −178.43;
PMT = 0.00; FV = 1,000; I = 4.403.]

c 64. Consider the following for a firm. Its stock price (P0) is at $50, its payout ratio
(POR) is 0.4, its EPS1 is $2.00, and its expected return on the money retained (i) is 0.10. What is
its required rate of return on equity?
a. 6.00%
b. 9.00%
c. 7.76%
d. 22.00%
[ANSWER: With POR constant, the next dividend (D1) is simply that proportion of the next
period's expected earnings per share, (EPS 1), or D1 = POR(EPS1). Substituting this and the
equation, g = (1 − POR)i, into the equation r = (D1 / P0) + g, we can express the firm's expected
return, as r = (D1 / P0) + g = [(POR)(EPS1) / P0] + (1 − POR)i = [(0.4)($2.0) / $50] +
(1 − 0.4)(0.1) = 0.016 + 0.060 = 0.076 or 7.76%.]
b 65. You own a stock that is currently selling for $50. You expect a dividend of $1.50
next year and you require a 12% rate of return.. What is the dividend growth rate for your stock
assuming constant growth?
a. 6.00%
b. 9.00%
c. 12.00%
d. 15.00%
[ANSWER: We can rearrange the equation for the dividend valuation model with constant
D
growth to solve for the dividend growth rate (g). Doing this, we have: g = r − 1 where r is the
P0
D
required rate of return and 1 is the dividend yield. (NOTE. The growth rate, g, is the capital
P0
gains yield and is often called the price appreciation.) Inserting the given values, we have: g =
$1.50
0.12 − = 0.12 − 0.03 = 9.00%.]
$50

c 66. What would you pay for a stock expected to pay a $2.50 dividend in one year if
the expected dividend growth rate is zero and you require a 10% return on your investment?
a. $18.75
b. $21.50
c. $25.00
d. $26.00
[ANSWER: According to the dividend valuation model with constant growth, the price of a share
D1
of stock (P0) is
( r - g ) where D1 is the dividend paid at the end of each period, r is the required
rate of return on equity, and g is the rate at which the dividends are growing. Inserting the given
$2.50
values, we have: P0 = ( = $25.00.]
0.10 - 0 )

d 67. Consider the following for a firm. Its stock price (P0) is at $50, its payout ratio
(POR) is 0.4, its EPS1 is $8.00, and its expected return on the money retained (i) is 0.10. What is
its dividend yield?
a. 7.00%
b. 6.50%
c. 6..00%
d. none of these
[ANSWER: With POR constant, the next dividend (D1) is simply that proportion of the next
period's expected earnings per share, (EPS 1), or D1 = POR(EPS1). We have the dividend yield =
D1 / P0 = (POR)(EPS1) / P0 = (0.4)($8.0) / $50 = 0.0640 or 6.40%.]

c 68. Consider the following for a firm. Its stock price (P0) is at $50, its payout ratio
(POR) is 0.4, its EPS1 is $2.00, and its expected return on the money retained i is 0.10. What is
the percent of capital gains?
a. 4.00%
b. 5.00%
c. 6.00%
d. none of these
[ANSWER: The capital gains = g = (1 − POR)i. We have: g = (1 − POR)i = (1 − 0.4)(0.1) = (0.6)
(0.1) = 0.06 or 6.00%.]
c 69. What would you pay for a stock expected to pay a $2.25 dividend in one year if
the expected dividend growth rate is 3% and you require a 12% return on your investment?
a. $20.00
b. $21.50
c. $25.00
d. $26.00
[ANSWER: According to the dividend valuation model with constant growth, the price of a share
D1
of stock (P0) is
( r - g ) where D1 is the dividend paid at the end of each period, r is the required
rate of return on equity, and g is the rate at which the dividends are growing. Inserting the given
$2.25
values, we have: P0 = ( = $25.00.]
0.12 - 0.03)

IV. Longer Problems

70. Suppose you purchase a zero coupon bond for $214.55 with a face value of $1,000
maturing in twenty years. If the yield to maturity (YTM) on the bond remains unchanged, what
will the price of the bond be at the end of five years from now?

ANSWER: We can follow this procedure. Sometimes we are given a present value, a future
FVn
value, and a time period. If so, we can derive a formula for r from the fact that PV = or
(1+ r) n
from FVn = PV(1 + r)n where PV is the present value, FV is the future value, and r is the yield to

( )
1
maturity, and n is the number of years. The equation is: r = FV n - 1 . In this problem, we
PV
have a future value ($1,000), a present value ($214.55), and a time period (n = 20). Inserting
these values, we can solve for r. Using this r value, we can compute the price of the bond in five
years from today by using the future value formula where FVn = PV(1 + r)n. In computing YTM

( ) ( )
1 1
or "r," we have: r = FV n - 1 = $1,000
20
- 1 = 0.0799995 or about 8.00%. In calculating
PV $214.55
FVn where n = 5, we have: FVn = PV(1 + r)t = $214.55(1.08)5 = $315.24.

71. DeBeers, Inc. is expected to pay cash dividends next year at the rate of $0.50 per quarter.
Its required return on stock is 14%. The stock is currently selling for $37.50 per share. Rearrange
the equation for the dividend growth model to solve for g. Then use this equation to solve for the
expected quarterly growth rate in dividends. What is the annual growth rate?

ANSWER: We have: D1 = $0.50 per quarter; r = 0.14/4 = 0.035 quarterly; P 0 = $37.50. The
dividend growth model states: P0 = D1/(r − g). Rearranging this equation to solve for g, we first
multiply for sides of this equivalent expression by (r − g) to get: (r − g)P 0 = D1. Multiplying out,
we have: P0r − P0g = D1. Dividing each side by P0, we have: r − g = D1/P0. Adding g to both sides
of the equation and subtracting D1/P0 from both sides, we have: g = r − D1/P0. Inserting our values
gives: g = 0.035 − ($0.50/$37.50) = 0.021667 or 2.1667% per quarter or about 4(2.1667%) =
8.667% per year. [NOTE. We can get the same answer for the annual growth rate using annual
data. We have: g = 0.14 − $2.00/$37.50 = 0.08667 or 8.667%.]
72. You are considering investing in Facial Laboratories. Suppose Facial is currently
undergoing expansion and is not expected to change its cash dividend while expanding for the
next 4 years. This means that its current annual $3.00 dividend will remain for the next 4 years.
After the expansion is completed, higher earnings are expected to result causing a 30% increase
in dividends each year for 3 years. After these three years of 30% growth, the dividend growth
rate is expected to be 2% per year forever. If the required return for Facial’s common stock is
11%, what is a share worth today?

ANSWER: We have two growth rates: g1 = 0.30 for years 5, 6, & 7 and g2 =0.02 beginning with
year 8 and lasting forever. Assuming annual dividends and annual rates of return (as opposed to
quarterly), we have: P0 =

D4 ( 1 + g1 ) D4 ( 1 + g1 ) D ( 1 + g1 ) D ( 1 + g1 ) ( 1 + g 2 )
2 3 3
D1 D2 D3 D4
+ + + + + + 4 + 4
(1+ r) 1
(1+ r) 2
(1+ r) 3
(1+ r) 4
(1+ r) 5
(1+ r ) 6
(1+ r) 7
( r - g 2 ) (1+ r ) 7
D4 ( 1 + g1 ) (1+ g 2 )
3

where D 1 = D 2 = D 3 = D4 and P7 = with D8 = D4 (1+g1)3(1+g2). Inserting in

( r - g 2 ) (1+ r) 7
the values given in our problem, we have:
2 3 3
$3 + $3 + $3 + $3 + $3 ( 1.3) + $3 ( 1.3) + $3 ( 1.3) + $3 ( 1.3) ( 1.02 )
P0 = 1 2 3 4 5 6 7 
( 1.11) ( 1.11) ( 1.11) ( 1.11) ( 1.11) ( 1.11) ( 1.11) ( 0.11 - 0.02 ) ( 1.11) 7

P0 = $2.7027 + $2.4349 + $2.19357 + $1.9762 + $2.31446 + $2.71063 + $3.1746 + $35.9789 

P0 = $53.49.

73. Your spouse has several investments. One of them is 500 shares of Royal Oil. Royal is
expected to pay a dividend next year of $2.38. The expected dividend growth rate is 6% per year
forever. Another of your spouse’s investments is 600 shares of Light House. It has an expected
growth rate in dividends of 4% per year forever. It sells for $51.875. It is expected to pay a
dividend of $3.35 per share next year. Answer the below questions.
(1) If Royal is selling for $29.45 per share, what is your spouse’s expected return on
Royal Oil?
(2) What is your spouse’s expected return on Light House?
(3) Does it appear if one of the investments is superior to the other? Explain.

ANSWER (1): The dividend valuation model with constant growth implies that r = (D1/P0) + g.
Inserting Royal Oil's value, we have: r = ($2.38/$29.45) + 0.06 = 0.14082 or about 14.08%.

ANSWER (2): The dividend valuation model with constant growth implies that r = (D1/P0) + g.
Inserting Light House's values, we have: r = ($3.35/$51.875) + 0.04 = 0.10458 or about 10.46%.

ANSWER (3): One might assume that Royal Oil is superior to Light House because it has a
greater expected return. However, if you recall the Risk-Return Tradeoff Principle, then you
realize that the greater return can be explained by greater risk. The market is driven by investors
who are risk averse. They will not take on additional risk without additional compensation. Thus,
one cannot conclude that a higher expected return leads to a superior investment. All we can say
is that, everything else being equal, investors will choose the stock with a greater return. There is
probably no need for your spouse to choose between either of the two assets. On the contrary,
your spouse might be advised to invest in other assets to achieve diversification.
74. You are considering investing in Acme, Inc. Suppose Acme is currently undergoing
expansion and is not expected to change its cash dividend while expanding for the next 4 years.
This means that its current annual 4.00 dividend will remain for the next 4 years. After the
expansion is completed, higher earnings are expected to result causing a 30% increase in
dividends each year for 3 years. After these three years of 30% growth, the dividend growth rate
is expected to be 2% per year forever. If the required return for Acme’s common stock is 11%,
what is a share worth today?

ANSWER: We have two growth rates: g1 = 0.30 for years 5, 6, & 7 and g2 =0.02 beginning with
year 8 and lasting forever. Assuming annual dividends and annual rates of return (as opposed to
quarterly), we have: P0 =

D4 ( 1 + g1 ) D4 ( 1 + g1 ) D ( 1 + g1 ) D ( 1 + g1 ) ( 1 + g 2 )
2 3 3
D1 D2 D3 D4
+ + + + + + 4 + 4
( r - g 2 ) (1+ r )
1 2 3 4 5 6 7 7
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (1+ r ) (1+ r)

D4 ( 1 + g1 ) (1+ g 2 )
3

where D 1 = D 2 = D 3 = D4 and P7 = with D8 = D4 (1+g1)3(1+g2). Inserting in

( r - g 2 ) (1+ r) 7
the values given in our problem, we have:
2 3 3
$4 + $4 + $4 + $4 + $4 ( 1.3) + $4 ( 1.3) + $4 ( 1.3) + $4 ( 1.3) ( 1.02 )
P0 = 1 2 3 4 5 6 7 
( 1.11) ( 1.11) ( 1.11) ( 1.11) ( 1.11) ( 1.11) ( 1.11) ( 0.11 - 0.02 ) ( 1.11) 7

P0 = $3.6036 + $3.2465 + $2.9248 + $2.6349 + $3.0860 + $3.6142 + $4.2328 + $47.9719 

P0 = $71.32.

75. Junk Bond, Inc. has 12.5 percent coupon bonds on the market with eight years left to
maturity. The bonds make annual payments. If the bond currently sells for $1,145.68, what is its
YTM? Other than using a financial calculator, describe other methods for working this problem?

ANSWER: Using a financial calculator, we get: 9.79%. Other than using a financial calculator,
there are two methods that can be used.

First is trial and error which may seek to estimate to the nearest tenth. Using this method, we see
that the current bond value is greater than its par value. This implies that the yield to maturity is
less than the coupon rate of 12.5 percent. We can try 11 percent as a first estimate. Using this
value in our bond valuation formula, we will get a value for B 0 that is still greater than the par
value of $1,000. The rule of thumb is to try a lower YTM. If we try 10 percent, we will still get a
value for B0 that is greater than par. Using 9 percent, we get a value for B 0 that is less than $1,000.
After a number of attempts, we can determine that the YTM is about 9.8%.

A second method involves a formula sometimes used to estimate YTM. This formula is: YTM =
CPN + ��( F - B0 ) / N �
�where F is the par value of the bond. Inserting our values, we have: YTM =
( F + 2 B 0 / 3)
$125 + [ ( $1, 000 - $1,145.68 ) / 8] $106.79
= $1,097.12 = 0.09734 or about 9.73%.
( $1,000 + $2, 291.36 / 3)

Both of our answers are close to the 9.79% given by a financial calculator.
V. Short Answers

76. What is a bond?

A long-term obligation for borrowed money.

77. What is a premium bond?

A bond that’s selling for more than its par value.

78. What is interest rate risk?

The risk of a change in the value of a bond because of a change in the interest rate.

79. What is the yield to call?

The APR of a bond, assuming it will be paid off at the first possible call date.

80. What is the payout ratio?

The firm's cash dividend divided by the firm's earnings in the same period.

81. What is a firm’s dividend policy?

An established guide for the firm to determine the amount of money it will pay out as dividends.
The dividend policy determines the payout ratio which is the proportion of earnings paid out as
dividends.

82. What is a bond indenture?

The legal contract detailing the terms of a bond between the issuing corporation and the
bondholders.

83. What is a coupon rate?

A bond's interest rate is its annual coupon payment divided by its face or par value. Its annual
coupon payment is the sum of its two semi-annual payments.

84. What is par value?

The amount of money to be repaid for a bond at the end of its life.

85. What are coupon payments?

Coupon payments are a bond's interest payments. These payments are an annuity.

86. What is a call provision?

A call provision is a provision found in a bond indenture that gives the issuer the right to pay off
the bonds prior to their maturity by paying a call price.
87. What is a maturity date?

A maturity date is the date a bond ends.

88. What is the original maturity?

When a bond is issued, the length of its life is its original maturity. The amount of time remaining
until maturity is called the remaining maturity. While any original maturity is possible, most U.S.
corporate bonds issued in recent years have had original maturities between 5 and 30 years.

89 What is a balloon payment?

When the final repayment of principal is larger than its par value then it is called a balloon
payment.

90. What is the fair price of a bond?

The fair price of a bond is the present value of its promised future coupon and principal
payments. This present value is determined by the bond’s required return, which is the minimum
rate of return an investor expects to receive if the bond is purchased.

91. What does bond data found in the financial pages typically include?

Bond data found in the financial pages typically include the coupon rate, the year of maturity, the
current yield, the trading volume, the closing price (quoted in 100s), and the net change in the
bond price.

92. What is the current yield? What does it ignore?

The current yield is the annual coupon payment divided by the closing dollar price. It ignores any
gain or loss between the purchase price and the principal repayment.

93. What is the yield to maturity or YTM?

The YTM is the APR that equates the bond's market price to the present value of its promised
future cash flows.

The yield to maturity (YTM) is the return that will be earned if all the payments are made exactly
as promised. Thus, the YTM can be viewed as the APR that makes the bond’s market price equal
the present value of its promised future cash flows.

94. Why is the yield to maturity (YTM) a better measure of the return than the current yield?

Even though not found in the typically bond data, the yield to maturity (YTM) is a better measure
of the return, because it measures the total return from owning a bond including capital
appreciation.

95. Name a publication where information on a common stock can be found?

Information on a common stock can be found in Standard & Poor's Stock Guide.
VI. Essays or Longer Answers

96. Suppose you buy a 9.75 percent coupon, 30-year bond when the bond is first issued. If
interest rates suddenly fall to 8.25 percent, what happens to the value of your bond? Why?
Suppose your bond is convertible. Does your answer change? Now suppose your bond can be
called at a premium equal to one coupon payment. How does this change your answer?

Price and yield move in opposite direction. If interest rates decrease, the price of the bond will
increase. This is because the fixed coupon payments determined by the fixed coupon rate are
more valuable when interest rates fall. Thus, the price of the bond increases.

With a convertible bond, the price is no longer just determined by how interest rates change. This
is because the value of the bond will be determined by its conversion value if the conversion
value is greater than the present value of all coupon and principal payments.

If your bond is callable, then the maximum price it can attain will be its par value plus some
designated premium. This value may very well be less than what could be attained if the bond’s
price was allowed to rise when rates fell or was allowed to rise due to the increase in its
conversion value.

97. Consider the dividend valuation model with constant growth. What happens if g equals r,
or if g is greater than r?

The question arises because if we blindly apply the dividend valuation model then it implies that
the stock’s value is infinite if g equals r and is negative if g is greater than r. Neither situation
makes economic sense. A faster-growing firm is riskier and will have a higher required return, so
the larger g is, the larger r will be. Quite simply, g can never be greater than or equal to r. To
understand this, consider the following argument: g is the rate at which cash dividends are
expected to grow every period, forever. In the long run, dividends are paid from a firm’s earnings.
Therefore, for cash dividends to grow at g, the firm’s earnings must grow at a rate that at least
equals (on average over a long time) to have sufficient income to pay the dividends. It is hard to
imagine any company sustaining large growth rates for a prolonged period of time. If they did,
then they could eventually “own” the world.

98. Discuss why it is unclear what a high or a low P/E really indicates without obtaining
additional information about the firm.

A high P/E typically is seen as positive because it results from investors bidding up the stock
price (P) based upon positive expectations about the firm’s future performance. The earnings (E)
component of the P/E ratio is a function of the firm’s earnings as reflected in its accounting
earnings. Thus, it can be noted that a high P/E (which is often deemed good) can also result from
a bad year while a low P/E (which is often deemed bad) can result from a good year. Because the
earnings value is an accounting number it is subject to change based upon atypical events like
selling assets which would inflate earnings. On the other hand, an increase in depreciation and
interest expense can cause a lower earnings number. All of these factors should be considered
when interpreting the meaning of a firm’s P/E.
99. Explain how retained earnings determine a firm’s growth in dividends and thus its rate of
D
return. Give an example showing the influence of retained earnings on the dividend yield ( 1 ),
P0
capital gains (g), and the required rate of return (r).

Cash flows that are not paid out in dividends become retained earnings and thus are invested in
other assets. This retained earnings is the source of the firm’s growth in earnings, which also
provides for the growth in the firm’s dividends. Recall that the firm’s payout ratio (POR) is the
proportion of earnings it pays out in dividends. Therefore, (1 − POR) is the amount the firm
retains and reinvests. Let i represent the expected return on the earnings retained. Growth is then
the product of the two: g = (1 − POR)i. Thus, as the amount that is retained and reinvested
D
increases then so does g increase. From the dividend valuation model we have: r = 1 + g.
P0
Thus, as g increases, the rate of return (r) increases. Furthermore, since Dn = (1+g)Dn−1, we can
D
also observe that as g increases so can r increase through an increase in the dividend yield ( 1 ).
P0

Consider the following example for a firm: stock price (P 0) = $75; payout ratio (POR) = 0.7; EPS1
= $2.00; and, its expected return on the money retained (i) = 0.10.With POR constant, the next
dividend (D1) is simply that proportion of the next period's expected earnings per share, (EPS 1),
D
or D1 = POR(EPS1). Substituting this and the equation, g = (1 − POR)i, into r = 1 + g, we can
P0
express the firm's expected return, as:
D ( POR ) ( EPS 1 )
r= 1 +gr= + (1 − POR)i.
P0 P0
Inserting in our values, we have:
( 0.7 ) ( $2.00 )
r= + (1 − 0.7)(0.1) = 0.0187 + 0.0300 = 0.0487 or 4.87%.
$75
We can see that the amount of earnings retained through its influence on (1 − POR), and thus
simultaneously on POR, affects both the dividend yield (1.87%) and capital gains (3.00%) and
thus the required rate of return (4.87%).

100. Discuss why stocks are riskier than bonds? Is this good or bad?

Stockholders are only paid after bondholders are paid. Bondholders have legal claims on the cash
flows of a firm and in case of default they are paid first. What this means in terms of risk is that
payments to stockholders are more variable. If the company performs poorly, then stockholders
will see the value of their holdings fall significantly. This is less likely to happen with the value of
bonds unless the company begins to experience serious financial distress. The fact stock has more
risk is not necessarily bad. The Risk-Return Tradeoff Principle states that greater return only
comes from taking on additional risk. For a long-term investor, this risk would be minimized
because short-run fluctuations in stock values would not be of great concern. However, for an
investor who needs money in the near term, the risk associated with stocks could have extreme
negative repercussions if stock prices plummet and the investor must sell stockholdings.