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Chapter 5 1. (Required return for a preferred stock) Preferred

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Chapter 5

1. (Required return for a preferred stock) Preferred Stock for Peachtree Products $5.54 is currently selling for $51.75: This is a non-growing preferred dividend. Given these, calculate the required return on Peachtree Products preferred stock.

2. (Constant growth model) While Dynamic Designs is profitable, it is not paying a dividend on its common stock. Joe Neimer, an analyst for Schwab, believes that Dynamic Designs will begin paying a $1.00 per share dividend in two years and that the dividend will increase 5% annually thereafter. Andy Neimer, Joe’s brother, is an analyst for Merrill Lynch and Andy is pessimistic about Dynamic Design’s future. Andy thinks that Dynamic Designs will begin paying a dividend in four years, that the dividend will be $1.00, and that it will grow at 3% annually. The brothers can agree on the required return for Dynamic Designs, which is 12%. a. What value would Joe estimate for this firm?

b. What value would Andy assign to the Dynamic Designs stock?

3. (Bond valuation) Compute the fair value of the following bond: The bond has a face value of $1,000 face value, 10 years remaining to maturity, a 9.0% coupon rate and an 11% required return. Remember to adjust for semi-annual bond payments.

4. (Interest-rate risk) The New York Stock Exchange trades many Oregon Timber bonds. With identical coupon rates of 8.075%, Oregon Timber has one issue that matures in 1 year, one in 7 years, and the third in 15 years. A coupon payment was made yesterday. (Set up a spreadsheet or a table to calculate these in an easier manner. Each question a-c below has a 1, 7 and 15 year answer.) a. If the yield to maturity for all three bonds is 8.25%, what is the fair price of each bond?

b. Suppose that the yield to maturity for all of these bonds changed instantaneously to 7.5%. 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 9.95%. Now what is the fair price of each bond?

d. Given the fair prices at the various yields to maturity, can you assume interest-rate risk the same, higher, or lower for longer- versus shorter-maturity bonds?

5. (Dividend discount model) Greta’s Coffee Roaster has experienced recent growth, which is expected to continue at a 5% rate per year forever. Next year, it plans on paying a total cash dividend of $10.25 next year increasing by 5% per year thereafter. Calculate the current market value of a share of Greta’s Coffee Roaster stock - given annual dividend payments - if the required return on Greta’s Coffee Roaster common stock is 11%.

6. (Stock valuation) Stockholm Meats has a perpetual preferred stock (non-maturing) currently outstanding that pays a $1.00 quarterly dividend. With a required return of 8% APR (2% per quarter), can you calculate what the stock is worth?

7. (Default risk) As an investment, Portland Capital Partners purchases an extremely risky bond that promises a 8.75% coupon and return of the $1,000 principal in 10 years. Portland Capital pays $500 for the bond. a. In the first four years, Portland Capital is paid the coupon payments as expected for four years and then the bond defaults. The bond-issuing firm liquidates and the bondholders receive a distribution of $225 per bond at the end of 4.5 years. What is the realized return on Portland Capital’s investment? (Hint: Remember to account for the two annual payments on bonds.)

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 Portland Capital’s investment? (Hint: Remember to account for the two annual payments on bonds.)

Chapter 7 1. (Beta and required return) Piper’s Knits has calculated the contingent returns shown below. The riskless return is currently 5.75%.

REALIZED RETURN (Figures in parentheses are negative returns.) State of the Market Probability that State Occurs Stock Market Piper’s Knits Stagnant 0.25 (10%) (15%) Slow growth 0.30 10 15 Average growth 0.30 15 25 Rapid growth 0.15 25 35

a. What is the expected return on the stock market taken as a whole and on Piper’s Knits as an individual stock?

b. Calculate Piper’s Knits’ beta.

c. Using the CAPM formula, calculate Piper’s Knits required return.