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Understanding Financial Management: A Practical Guide
Problems and Answers
Chapter 5
Valuation
5.1 Valuation Fundamentals
1. An analyst wants to estimate the discount rate on a security. The real risk-free rate is 4.5%
and the expected inflation rate is 3.2%. Given the characteristics of this investment, the
analyst assigns a 5.0% risk premium.
A. What is the estimated required rate of return on this security?
B. How much does this amount differ using the exact and the approximation formulas?
2. An analyst estimates the real risk-free rate of return for a financial asset to be 5%, the
inflation premium 2%, and the risk premium 7%.
A. What is the nominal required rate of return for this asset?
B. By how many basis points does the approximation formula understate or overstate the
nominal required rate of return?
5.2 Bond Characteristics and Features
3. Tylor Inc. issued a 15-year, annual-pay bond with a 9% coupon rate and a $1,000 par
value. At the time of issue, investors required an 11% rate of return. How much yearly
interest will this bond pay?
4. Amertron’s floating rate bonds have a par value of $1,000 and are currently trading at
104% of par. The floating rate is based on the 3-month LIBOR plus a margin of 135 basis
points with an interest rate cap of 6.50%.
A. At what price does the bond currently trade?
B. If the 3-month LIBOR is 5.50% and the bond pays semi-annual coupon payments,
what is the current interest rate and coupon payment on the bond?
5.3 Bond Valuation
5. Eiffel Corporation issued an annual-pay bond with a $1,000 par value and an 8% coupon
rate 15 years ago. The bond has 5 years remaining until maturity. The risk-free rate is 5%,
and the expected inflation premium is 3%. Investors require a 2% risk premium. What is
the intrinsic value of the bond?
6. Pixy Inc. issued a 20-year, annual-pay bond with a 9.0% coupon rate and a $1,000 par
value. At the time of issue, investors required an 8.8% rate of return.
A. What was the value of the annual-pay bond when it was issued?
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B. Today, the bond has 8 years remaining until maturity and investors expect a required
rate of return of 10%. What is the value of the annual-pay bond today?
7. Dual Corporation is offering a 15-year, $1,000 par, 7% semiannual-pay bond. If an
investor requires a 9% return on this bond, what is its intrinsic value?
8. Anderson Company has a 20-year, $1,000 par, and 12% semiannual-pay bond. If
investors require a 10% rate of return on this bond, what is its intrinsic value?
9. Hobson Corporation is offering a 20-year, zero coupon bond with at a par value of $1,000.
Investors require an 8% rate of return
A. What is the bond’s value assuming annual compounding?
B. What is implied interest earned by the bondholder?
C. What is the bond’s value assuming semi-annual compounding?
10. Lakewood Inc. has a 10-year, zero-coupon bond with a $1,000 maturity value. Assuming
semi-annual compounding, what is the intrinsic value of the bond if investors require an
8% rate of return?
5.4 Bond Pricing Relationships
11. Golden Gate Corporation has a bond issue outstanding with a $1,000 par value, and an
8% coupon rate, paid semi-annually. The bond has 12 years until maturity. If the required
rate of return 6%, 8%, 14%, what is the value of the bond?
12. Added Value Inc. issued an option-free 15-year, $1,000 par, 8% semiannual-pay bond five
years ago.
A. If investors now require a 10% rate of return on this bond, is the bond selling at a
discount or premium? Why?
B. Now assume that investors require a 6% rate of return on this bond. By what
percentage does the value of the bond exceed the par value? What bond pricing
property does this illustrate?
5.5 Interest Rate Risk
13. Eagle Corporation has two bonds outstanding. Both bonds have a 7% coupon rate, pay
interest semiannually, plus $1,000 at maturity. Bond S matures in 1 year and Bond L
matures of 12 years. If the current rate of interest is 6.5%, 7%, and 8%, what is the value
of each bond?
5.6 Bond Yields
14. A 10-year bond with a $1,000 par value is currently selling for $1,250. The bond has 9%
coupon payments paid semiannually. What is the bond’s current yield?
15. Wolfson Company bonds have 9 years remaining until maturity. The bonds have an 8%
coupon interest rate, paid annually, and a $1,000 par value. If the bonds are currently
trading at a price of $910 or $1,200, what is the yield to maturity?
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16. Hamlin Corporation’s bonds mature in 10 years. The bonds have a 9% coupon rate, paid
semiannually, and a par value of $1,000. If the bonds are currently trading at $925, what is
their yield to maturity?
17. Atlas Company has bonds outstanding that will mature in 15 years. The bonds have a
10% coupon rate, paid semiannually, and a par value of $1,000. The bonds currently trade
at $1,200 and are first callable in 7 years at a call price of $1,100.
A. What is the yield to maturity?
B. What is the yield to first call?
5.8 Preferred Stock Features and Valuation
18. The Reef Inc. has a $25 par value preferred stock that pays an annual dividend of $2. If
investors require a 7% return on this preferred stock, what is its intrinsic value?
19. Indies Corporation has preferred stock outstanding with a $100 par value that pays a $5
annual dividend. If investors require a 9% return for this preferred stock, what is its intrinsic
value?
20. Beight Corporation has preferred stock that currently sells for $90 per share. If the
preferred stock pays an annual dividend of $8, what is the preferred stock’s expected rate
of return?
21. Assume that the preferred stock of Holmes Corporation is selling for $26 and pays annual
dividends of $2.00. Investors require an 8% return because the company has recently
been experiencing financial difficulties.
A. What is the expected rate of return?
B. Should investors buy the stock?
5.10 Common Stock Valuation
22. An investor plans to buy El Zonte Company common stock and to sell it at the end of three
years. The firm’s ROE of 12% and its dividend payout policy of 60% are expected to
remain constant in the future. The investor forecasts the stock price to be $55 three years
from now. The firm paid a dividend of $1.50 last year. The current nominal risk free rate is
4%, the expected market return is 9%, and El Zonte’s beta is 1.3.
A. What is the firm’s growth rate?
B. What is the amount of the dividends paid in the next three years?
C. What is the required rate of return?
D. What is the stock’s intrinsic value?
23. An investor plans the buy the common stock in Wonder Corporation with the intention of
selling the stock at the end of 3 years. Wonder Corporation just paid a dividend of $1 (D0).
Wonder’s return on equity (ROE) is 12% and investors expect it to remain at this rate in
the future. Wonder’s earnings retention rate is 75% and will remain at this level in the
future. The investor expects that Wonder’s stock price will be $40 at the end of the three
years. The current nominal risk-free rate is 4.5%, the market risk premium is 6%, and
Wonder’s beta is 0.98. What is the intrinsic value of Wonder’s common stock?
24. Reef Aquatics Inc. paid a $3.00 dividend last year. Analysts expect the firm’s dividends to
grow at a constant 5% a year. If investors require a 12% return, what is the intrinsic value
of Reef Aquatic’s stock?
25. FDR Corporation is expected to pay a dividend of $1.50 per share at the end of the year.
Analysts forecast a constant dividend growth rate of 8% per year. If investors require a
16% rate of return, what is the intrinsic value of FDR’s common stock?
26. GBA Corporation recently paid a dividend of $3 per share. GBA expects the dividend to
grow at a rate of 15% per year for the next 3 years, and then the dividend is expected to
grow at a rate of 6% per year thereafter. The current nominal risk-free rate is 5%, the
expected market return is 12%, and GBA’s stock has a beta of 1.3. What is the value of
GBA’s stock today?
27. Analysts expect dividends at VN Corporation to grow at a rate of 15% for the next three
years, 10% for the following two years, and 6% a year thereafter. The company paid a
dividend of $3 per share last year and investors require a return of 14%.
A. What is the present value of the dividends during the supernormal growth period (first
three years)?
