FM Assignment

Meeting 3
Ch 5: 5-11, 5-22
5-11
Goodwynn & Wolf Incorporated (G&W) issued a bond 7 years ago. The bond had a 20-year maturity,
a 14% coupon paid annually, a 9% call premium and was issued at par, $1,000. Today, G&W called
the bonds. If the original investors had expected G&W to call the bonds in 7 years, what was the yield
to call at the time the bonds were issued?
Answer:
N = 20
t =7
PMT = $140 (14% *1000)
rd = 9%
PV = 1,000
Call price = 1,090 (1000*(1+9%)

YTC = 14.82%

YTC ?
0 1 2 … 7 8 … 20
-1000 140 140 140 1,090
PV PMT PMT PMT Call price

5-22
Arnot International’s bonds have a current market price of $1,200. The bonds have an 11% annual
coupon payment, a $1,000 face value, and 10 years left until maturity. The bonds may be called in 5
years at 109% of face value (call price 5 $1,090).
a. What is the yield to maturity?
Answer:

b. What is the yield to call if they are called in 5 years?

 Answer:

c. Which yield might investors expect to earn on these bonds, and why?
Answer:
YTC because YTC < YTM. Bond will be called in 5 years; investors are expected to earn 7.59%

d. The bond’s indenture indicates that the call provision gives the firm the right to call them at the
end of each year beginning in Year 5. In Year 5, they may be called at 109% of face value, but
in each of the next 4 years the call percentage will decline by 1 percentage point. Thus, in Year
6 they may be called at 108% of face value, in Year 7 they may be called at 107% of face value,
and so on. If the yield curve is horizontal and interest rates remain at their current level, when
is the latest that investors might expect the firm to call the bonds?
Answer:

The company will likely call the bond as long as YTC < YTM. The latest would be by the end
of year 7 the bond will be called.
Ch 6: 6-6, 6-12
6-6
The market and Stock J have the following probability distributions:

a. Calculate the expected rates of return for the market and Stock J.
Answer:
 Rate of return Product
Probability (1) rm (2) rj (3) rm (1)*(2) rj (1)*(3)
0.3 15% 20% 4.50% 6.00%
0.4 9% 5% 3.60% 2.00%
0.3 18% 12% 5.40% 3.60%
Expected rate of
13.50% 11.60%
return

b. Calculate the standard deviations for the market and Stock J

Answer:

Stock J
Rate of Return Expected Deviation from Squared Deviation Sq. Dev * Prob
Probability (1)
on Stock J (2) Return (3) Expected Return (4) (4)^2 = (5) (5)*(1)
0.3 20% 11.60% 8.40% 0.71% 0.21%
0.4 5% 11.60% -6.60% 0.44% 0.17%
0.3 12% 11.60% 0.40% 0.00% 0.00%
Sum = Variance = 0.39%
Std Dev = sqrt(variance) = 6.22%

6-12
Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on an average stock is
13%, and the risk-free rate is 7%. By how much does the required return on the riskier stock exceed
that on the less risky stock?
Answer:
bR = 1.5
bS =0.75
rRF = 7%
rM = 13%

rR = rRF + (rM – rRF) bR

= 7% + (13% – 7%) 1.5
= 16%
rs = rRF + (rM – rRF) bs
= 7% + (13% – 7%) 0.75
= 11.5%
Difference of required of return is 4.5% (16% – 11.5%).
Stock R is riskier than stock S because R’s beta is higher than stock S.
Meeting 4
Ch 7: 7-12, 7-14
7-12
Kendra Enterprises has never paid a dividend. Free cash flow is projected to be $80,000 and $100,000
for the next 2 years, respectively; after the second year, FCF is expected to grow at a constant rate of
8%. The company’s weighted average cost of capital is 12%.
a. What is the terminal, or horizon, value of operations? (Hint: Find the value of all free cash
flows beyond Year 2 discounted back to Year 2.)
Answer:
FCF1 = $80,000
FCF2 = $100,000
g = 8%
WACC = 12%
Ther terminal /horizon date is on year 2, that means the value of operations is
V = (FCF(1+g))/ (WACC – g)
V = (100000(1+0.08) / (0.12 – 0.08)
= $ 2,700,000
b. Calculate Kendra’s value of operations.
Answer:

7-14
Brushy Mountain Mining Company’s coal reserves are being depleted, so its sales are falling. Also,
environmental costs increase each year, so its costs are rising. As a result, the company’s free cash flows
are declining at the constant rate of 4% per year. If its current free cash flow (FCF 0) is $6 million and
its weighted average cost of capital (WACC) is 14%, what is the estimated value of Brushy Mountain’s
value of operations?
FCF0 = $6,000,000
G = -4%
WACC = 14%
V = (FCF(1+g))/ (WACC – g)
= (6000000(1+(-0.04)))/ (0.14 – (-0.04))
= $32 million

Ch 8: 8-3, 8-5
8-3
Assume that you have been given the following information on Purcell Corporation’s call options:
Current stock price = $15 Strike price of option = $15
Time to maturity of option = 6 months Risk-free rate = 6%
Variance of stock return = 0.12
d1 = 0.24495 N(d1 ) = 0.59675
d2 = 0.00000 N(d2 ) = 0.50000
According to the Black-Scholes option pricing model, what is the option’s value?
Answer:
P = 15 X = 15
t = 0.5 (6 months) rRF = 6% Variance of stock return = 0.12
d1 = 0.24495 N(d1 ) = 0.59675
d2 = 0.00000 N(d2 ) = 0.50000

Vc = P[N(d1)] – Xe-rRF*t[N(d2)]
= 15(0.59675) – 15 e-0.06*0.5 (0.50000)
= 1.67291 (approx.)
8-5
Use the Black-Scholes model to find the price for a call option with the following inputs: (1) current
stock price is $30, (2) strike price is $35, (3) time to expiration is 4 months, (4) annualized risk-free rate
is 5%, and (5) variance of stock return is 0.25.
Answer:
P = $30
X = $35
t = 0.333 (4 months)
rRF = 5%
σ 2
= 0.25 σ = 0.5

d1 = (In(P/X) + [rRF + (σ2 /2)]t) / σ t-2

= (In(30/35) + [0.05 + 0.25 /2)]0.333) / 0.5*0.333-2
= -0.33192 (approx.)s
d2 = d1 – σ t^-2
= -0.33192 – (0.5 0.333^2)
= -0.6206
N(d1 ) = NORMSDIST(-0.33192)
= 0.369974
N(d2 ) = NORMSDIST(-0.6206)
= 0.267433

Vc = P[N(d1)] – Xe-rRF*t[N(d2)]
= (30*0.369974) – (35*e-0.05*0.33(0.267433))
= 1.8938 (approx.)