The University of Hong Kong

Faculty of Business and Economics

FINA2312—Advanced Corporate Finance

Assignment 1 Due: September 24, 2020

1. You have a cash obligation of $132,240 to be made at the end of year 5. Show how you
can use coupon bonds with a coupon rate of 8%, a face value of $1,000, a maturity
date at the end of year 6, and a yield to maturity of 8% to ensure that you can meet
your cash obligation at the end of year 5. Suppose that you purchase the bonds at the
beginning of year 1 and that the market interest rate changes only once right after
you have purchased the bonds. There are three possible interest rates, 7.9%, 8%, and
8.1%, each of which occurs with probability 1/3.

2. Consider a 6-year 5.5% coupon bond that is rated BBB when issued at par (i.e.,
$1,000) at the beginning of this year. Assume that the recovery rate is 46% of the
face value in the case of default.

Rating one year later Probability Yield

AAA 0.03 4.43
AA 0.21 4.56
A 4.56 4.8
BBB 89.38 5.5
BB 4.82 9.45
B 0.68 11.7
CCC 0.24 15.15
Default 0.08 —

(a) Plot the probability distribution of the bond value one year later, where the
first-year coupon is included. What do you find?
(b) What is the expected value of the bond one year later? What is the standard
deviation of the bond value one year later?
(c) If you plan to hold this bond for one year, what is the VAR in dollar terms at
the 99% confidence level assuming that the bond value is normally distributed?
What is the VAR in dollar terms at the 99% confidence level using the true
distribution of the bond value? Are these two VARs the same?

1
3. Compost Science, Inc. (CSI), is in the business of converting Boston’s sewage sludge
into fertilizer. The business is not in itself very profitable. However, to induce CSI to
remain in business, the Metropolitan District Commission (MDC) has agreed to pay
whatever amount is necessary to yield CSI a 10% book return on equity. At the end
of 2005, CSI is expected to pay a $4 dividend per share. It has been reinvesting 40%
of earnings and growing at 4% a year.

(a) Suppose CSI continues on this growth trend. What is the expected long-run rate
of return from purchasing the stock at $100 per share at the beginning of 2005?
What part of the $100 price is attributable to the present value of the growth
opportunities?
(b) Now, at the beginning of 2005, the MDC announces a plan for CSI to treat
Cambridge sewage. CSI’s plant will, therefore, be expanded gradually over 5
years. This means that CSI will have to reinvest 80% of its earnings for five years.
Starting in 2010, however, it will again be able to pay out 60% of earnings. What
will be CSI’s stock price once this announcement is made and its consequences
for CSI are known?

4. “If a perpetual security pays an annual payment that grows at a constant rate, g, the
price of the security also appreciates at the same rate, g.” Is this statement correct?
If yes, give a proof. If no, give a counter-example.