Choose the correct answer from the following choices. Make your selection clear and distinct, otherwise you will not get credit. 1. If then which of the following statement is correct The fir

Multiple Choice Questions: (10 points)

Choose the correct answer from the following choices. Make your selection clear and distinct, otherwise you will not get credit.

If then which of the following statement is correct

The firm offers superior investment opportunities.
The value of the firm increases as plowback ratio b increases.
Investors prefer that the firm payout earnings as dividends rather than reinvest earnings in the firm at an inadequate rate of return.
The stock price is unaffected by the plowback ratio. Investors are indifferent

Which of the following statements is correct with regard to bond valuation:

All else equal, the longer the time to maturity, the smaller the interest rate risk.
All else equal, the higher the coupon rate, the greater the interest rate risk
When coupon rate is lower than the market interest rate, the bond will sell at a premium.
Bond price will fall as the market interest rate rises, as the present value of the bond’s future cash flows is obtained by discounting at a higher interest rate.

3. MRP in the CAPM is also known as _______.

A) most risky portfolio

B) excess market return

C) most risky performance

D) choice of risk-free asset

4. You would certainly prefer a multistage dividend growth model to a constant-growth dividend discounted model when

A) the firm is experiencing supernormal growth

B) the firm is experiencing subnormal growth

C) the firm is growing at a low rate

D) the firm is hardly growing at all

5. All other things equal, which of the following bond price is more sensitive to interest rate changes?

A. a 10 year bond with a 10% coupon

B. a 20 year bond with a 7% coupon

C. a 20 year bond with a 10% coupon

D. a 30 year bond with 7% coupon

Conceptual Questions (6 points)

Question 1 (3 points)

Consider a semiannual bond with an 8% coupon and with yield to maturity 10%. If the bond’s YTM remains constant, then in one year, will the bond price be higher, lower, of unchanged? Why?

Question 2 (3 points)

What will be the duration of a zero coupon bond maturing in 5 years. Would the duration of the zero coupon bond be lower or higher than that of a 10% coupon bond maturing in 5 years. Provide a brief reasoning.

Small Problems (10 points)

i)Suppose you are thinking of purchasing the stock of ABC, Inc. and you expect it to pay a $2 dividend in one year from now, and dividend of $2.40 in two year from now and you believe that you can sell the stock for $13.50 at the end of year 2. If you require a return of 10% on investments of this risk, what is the intrinsic value of the stock at current year?

(3 points)

ii)MM Corporation (MMC) will pay a year-end dividend of $4, and dividends thereafter are expected to grow at 4% per year. The risk-free rate is 5%, and the expected return on the market portfolio is 10%. The stock has a beta of 0.75. What is the intrinsic value of the MMC stock?

(3 points)

iii)Brothers Corp expects to earn $6 per share next year. The firm’s ROE is 15% and its plowback ratio is 50%. If the firm’s market capitalization rate is 13%, what is the present value of its growth opportunities?

(3 points)

iv)Finance Corporation’s free cash flow is reported as $200 million. The firm’s interest expense is $22 million. Assume the tax rate is 35% and the net debt of the firm increases by $3 million. What is the market value of equity if the free cash flow to equity (FCFE) is projected to grow at 3% indefinitely and the cost of equity is 10%?

(3 points)

Problem 1 (20 points)

The current yield curve for default free zero coupon bonds is as follows:

Maturity (Years)	YTM
	8%
	9%
	10%

What are the implied one-year forward rates for the years 2 and 3? (5 points)

Problem 1 (continued)

What will the pure yield curve (that is, the yield to maturity on one and two year zero coupon bonds) be next year? (5 points)

The market price of a security is $50. Its expected rate of return is 13%. The risk-free rate is 4% and the market risk premium is 6%. What will be the market price of the security if its beta doubles (and all other variables remain unchanged)? Assume the stock is expected to pay a constant dividend in perpetuity. (10 points)

Problem 2 (25 points)

In year 2008, Janet’s firm is using a two stage dividend discount model (DDM) to find the intrinsic value of SmileWhite Co.

Let the risk free interest rate is 4.5% and expected return of market is 14.5% and beta of the SmileWhite Co. is 1.15.

In 2008, dividend per share is $1.72 for the company. Dividends are expected to grow at a rate of 12% per year for the next three years till 2011. After 2011 dividend growth rate will be at constant rate 9% per year indefinitely.

Calculate the required return by the market for SmileWhite Co. stock. (5 points)

What was the intrinsic value of SmileWhite Co. stock when the analyst was evaluating the stock (that is in year 2008)? (15 points)

Problem 2 (continued)

If the price of SmileWhite Co. was $35.00 at the time of this evaluation process in year 2008, was the stock overpriced or underpriced security considering the intrinsic value obtained by the two-stage DDM. What should be the trading strategy based on the evaluation. (5 points)

Problem 3 (15 points)

Suppose a semiannual bond was issued several years ago when the interest rate was 7%. The bond’s annual coupon rate was thus set at 7%. With 8 years left in bond’s life, the interest rate is 6% per year until the end of maturity.

A. What is the price of the bond 8 years prior to expiration? (4 points)

Problem 3 (continued)

B. What will be the bond’s price six years prior to maturity? (4 points)

C. An investor purchases the bond eight years prior to maturity and sells the bond six years prior to maturity. What is the total return of the investor from investing into the bond? What conclusion can you draw from the return? (7 points)

Problem 4 (14 points)

An 8% annual coupon bond has three years until maturity.

What is the duration of the bond if the yield to maturity is 8%? (7 points)

Problem 4 (continued)

A 30-year maturity bond making annual coupon payments with a coupon rate of 12% has duration of 11.54 years and convexity of 192.4. The bond currently sells at a yield to maturity of 8%.

Find the price of the bond at 8% YTM and also if its YTM falls to 7%.
What price would be predicted by the duration method if the YTM falls to 7%?
Would the price predicted by the duration-with-convexity method, if YTM falls to 7%, be more accurate or less accurate than just the duration method?

(7 points)