978-1259291814 Chapter 18 Solution Manual

Chapter 18: Financial Markets

Solutions Manual

Learning Objectives for Chapter 18

After reading this chapter, you should know

LO 18-01. How present discounted values are computed.

LO 18-02. The difference between stocks and bonds.

LO 18-03. Key financial parameters for stocks and bonds.

LO 18-04. How risks and rewards are reflected in current values.

Questions for Discussion

1. If there were no organized financial markets, how would an entrepreneur acquire resources to

develop and produce a new product? (LO 18-02)

2. Why would anyone buy shares of a corporation that had no profits and paid no dividends?

What’s the highest price a person would pay for such a stock? (LO 18-03)

3. Why would anyone sell a bond for less than its face (par) value? (LO 18-03)

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4. If you could finance a new venture with either a stock issue or bonds, which option would

you choose? What are their respective (dis)advantages? (LO 18-02)

5. Why is it considered riskier to own stock in a software company than to hold U.S. Treasury

savings bonds? Which asset will generate a higher return? (LO 18-04)

6. How does a successful IPO affect WHAT, HOW, and FOR WHOM the economy produces?

(LO 18-02)

7. What considerations might have created the difference between the coupon rate and current

yield on GM bonds (Table 18.5)? (LO 18-03)

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8. What is the price of Alibaba (BABA) stock today? How much has it risen or fallen from its

closing price on the first day of public trading (News, p. 393)? What might explain this

change? (LO 18-04)

9. Could Facebook have become a premier social networking site without venture capitalists?

How? (LO 18-02)

10. Why do people say “a dollar today is worth more than a dollar tomorrow?” (LO 32-01)

Problems

1. If an $80 stock pays a quarterly dividend of $1, what is the implied annual rate of return?

(LO 18-03)

Feedback: The total annual dividends are $4 since quarterly dividends are $1. The implied

annual rate of return is $4 for the $80 stock investment, or $4/$80, which is 5 percent.

2. If a $24 per share stock has a P/E ratio of 12 and pays out 40 percent of its profits in

dividends,

(a) How large is its dividend?

(b) What is the implied rate of return? (LO 18-03)

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Answers:

Feedback:

(a) Price/earnings (P/E) ratio is the price of a stock share dividend by earnings (or profit)

(b) Since this stock pays out 40 percent of its profits in dividends, the dividend is equal to

(c) The dividend per share is $0.80 (= 0.4 x $2.00). The implied rate of return is the dividend

3. According to the data in Table 18.3,

(a) How much profit per share did Google earn?

(b) How much of that profit did it pay out in dividends? (LO 18-03)

Answers:

Feedback:

(a) Profit per share is equal to the price of the stock share divided by the P/E ratio.

(b) According to the table, Google does not pay dividends.

4. According to the data in Table 18.3,

(a) How much profit per share did Intel earn?

(b) How much of that profit did it pay out in dividends? (LO 18-03)

Answers:

Feedback:

(a) Profit per share is equal to the price of the stock share divided by the P/E ratio.

(b) According to Table 18.3, Intel paid out 0.90 of profits in dividends. Since profits were

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5. At the closing price for the first day or Alibaba stock trades (News, p. 393), what was

(a) The P/E ratio?

(b) The rate of return?

(LO 18-03)

Answer:

Feedback:

(a) P/E ratio = Price of stock share / Earnings (profit) per share

(b) The implied rate of return is the dividend paid per share divided by the price of a share.

6. If the market rate of interest is 4 percent, what is the present discounted value of $1,000 that

will be paid in

(a) 1 year?

(b) 5 years?

(c) 10 years? (LO 18-01)

Answers:

Feedback:

Present discounted value (PDV) is the value today of future payments, adjusted for interest

7. What is the present discounted value of $10,000 that is to be received in 2 years if the market

rate of interest is

(a) 0 percent?

(b) 5 percent?

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(c) 10 percent? (LO 18-01)

Answers:

(a) $10,000.

Feedback:

Present discounted value (PDV) is the value today of future payments, adjusted for interest

accrual.

(a) Thus, the PDV of $10,000 in n = 2 periods at an interest rate of 0 percent remains

$10,000.

(b) If the interest rate is 5 percent, the PDV = ($10,000/ (1.05)2) = $9,070.29.

(c) If the interest rate is 10 percent, the PDV = ($10,000/ (1.10)2) = $8,264.46.

8. What was the expected return on Columbus’s expedition, assuming that he had a 50 percent

chance of discovering valuables worth $1 million, a 25 percent chance of bringing home only

$100,000, and a 25 percent chance of sinking? (LO 18-04)

Answer: $525,000.

Feedback:

The expected return on Columbus’s expedition was the probability of the return times the

9. Compute the market price of the GM bonds described in Table 18.5 if the yield falls to 20

percent. (LO 18-03)

Answer: $418.75.

Feedback:

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10. What is the current yield on a $1,000 bond with a 5 percent coupon if its market price is

(a) $900?

(b) $1,000?

(c) $1,100? (LO 18-03)

Answers:

Feedback:

Market price of the bond = Annual interest payment (or coupon rate) / Current yield

11. How much interest accrued each day on the immediate cash payoff of the MegaMillions

jackpot? (See Table 18.1) (LO 18-04)

Feedback:

At an interest rate of 4.47 percent, if the lottery winner chooses to take the immediate lump

12. Illustrate with demand and supply shifts the impact of the following events on stock prices:

(a) A federal court finds Google guilty of antitrust violations. Which way (right or left) did

(i) Demand shift?

(ii) Supply shift?

(b) Intel announces a new and faster processor. Which way did

(i) Demand shift?

(ii) Supply shift?

(c) Corporate executives announce they intend to sell a large block of stock. Which way did

(i) Demand shift?

(ii) Supply shift?

(d) Google enhances its search capabilities. Which way did

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(i) Demand shift?

(ii) Supply shift? (LO 18-04)

Answers:

If a federal court find Google guilty of antitrust violations, fewer individuals would be

interested in buying Google stock (demand would shift left), and more individuals who

(b) i. Demand shifts to the right.

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(d) i. Demand shifts to the right.

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Feedback:

(a) If a federal court find Google guilty of antitrust violations, fewer individuals would be

(b) If Intel announces a new and faster processor, many more people would have confidence

(c) If corporate executives were to announce the sale of a large block of stock, supply would

(d) If Google enhances its search capabilities, this would cause greater interest in the

13. Which investment has a higher rate of annual cash return? Investment A: $1,000 bond with a

coupon rate of 4 percent selling for $1,200; or Investment B: $1,000 stock with a P/E ratio of

10 that pays out half its profits in dividends. (LO 18-02)

Feedback:

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