FIN 571 WEEK 2 HOMEWORK APPENDIX 1ANSWER KEY
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Solution Guide / Answer Key:
1  (Bond valuation) A $1,000 face value bond has a remaining maturity of 10 years and a required return of 9.25%. The bond’s coupon rate is 7.5%. What is the fair value of this bond?
2  (Dividend discount model) Assume RHM is expected to pay a total cash dividend of $5.80 next year and its dividends are expected to grow at a rate of 6.5% per year forever. Assuming annual dividend payments, what is the current market value of a share of RHM stock if the required return on RHM common stock is 10.5%?
3  (Required return for a preferred stock)
4  (Stock valuation) Suppose Toyota has nonmaturing (perpetual) preferred stock outstanding that pays a $1.10 quarterly dividend and has a required return of 13.5% APR (3.375% per quarter). What is the stock worth?
5  (Interestrate risk) Philadelphia Electric has many bonds trading on the New York Stock Exchange. Suppose PhilEl’s bonds have identical coupon rates of 9.2% but that one issue matures in 1 year, one in 8 years, and the third in 14 years. Assume that a coupon payment was made yesterday.
a. If the yield to maturity for all three bonds is 9%, what is the fair price of each bond?
b. Suppose that the yield to maturity for all of these bonds changed instantaneously to 8%. 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 10%. Now what is the fair price of each bond?
d. Based on the fair prices at the various yields to maturity, is interestrate risk the same, higher, or lower for longer versus shortermaturity bonds?
6  (Default risk) You buy a very risky bond that promises a 9.75% 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 $155 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?
7  (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 7% 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 4.5% annually. James and Bret agree that the required return for Medtrans is 12%.
a. What value would James estimate for this firm?
b. What value would Bret assign to the Medtrans stock?
Chapter 7
1  Beta and required return) The riskless return is currently 4%, and Chicago Gear has estimated the contingent returns given here.
a. Calculate the expected returns on the stock market and on Chicago Gear stock.
b. What is Chicago Gear’s beta?
c. What is Chicago Gear’s required return according to the CAPM?


Realized Return 

State of the Market 
Probability that State Occurs 
Stock Market 

Stagnant 
0.25 
(10%) 
(15%) 
Slow growth 
0.30 
10% 
15% 
Average growth 
0.35 
15% 
28% 
Rapid growth 
0.10 
28% 
35% 
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