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Corporate Finance B16, B18, B20-ANSWER KEY

Corporate Finance B16, B18, B20-ANSWER KEY
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Solution Guide / Answer Key:

 

B16. (Interest-rate risk) Philadelphia Electric has many bonds trading on the New York Stock Exchange. Suppose PhilEl’s bonds have identical coupon rates of 9.125% but that one issue matures in 1 year, one in 7 years, and the third in 15 years. Assume that a coupon payment was made yesterday.

 

a. If the yield to maturity for all three bonds is 8%, what is the fair price of each bond?

 

b. Suppose that the yield to maturity for all of these bonds changed instantaneously to 7%. What is the fair price of each bond now?

 

c. Suppose that the yield to maturity for all of these bonds changed instantaneously again, this time to 9%. Now what is the fair price of each bond?

 

d. Based on the fair prices at the various yields to maturity, is interest-rate risk the same, higher, or lower for longer- versus shorter-maturity bonds?

 

 

 

B18. (Default risk) You buy a very risky bond that promises a 9.5% coupon and return of the $1,000 principal in 10 years. You pay only $500 for the bond.

 

a. You receive the coupon payments for three years and the bond defaults. After liquidating the firm, the bondholders receive a distribution of $150 per bond at the end of 3.5 years. What is the realized return on your investment?

 

b. The firm does far better than expected and bondholders receive all of the promised interest and principal payments. What is the realized return on your investment?

 

 

 

B20. (Constant growth model) Medtrans is a profitable firm that is not paying a dividend on its common stock. James Weber, an analyst for A. G. Edwards, believes that Medtrans will begin paying a $1.00 per share dividend in two years and that the dividend will increase 6% annually thereafter. Bret Kimes, one of James’ colleagues at the same firm, is less optimistic.

Bret thinks that Medtrans will begin paying a dividend in four years, that the dividend will be $1.00, and that it will grow at 4% annually. James and Bret agree that the required return for Medtrans is 13%.

a. What value would James estimate for this firm?

b. What value would Bret assign to the Medtrans stock?

 

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