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The document contains three investment scenarios: 1) A risky bond that defaults after 3 years, paying the bondholder $150. The realized return is 37.34%. 2) The same bond, but the firm does better and pays all promised interest and principal over 10 years. The realized return is 22.42%. 3) An analyst estimates a stock will pay dividends starting in 2 years of $1, growing 6% annually. The stock is valued at $15.14. A second analyst estimates dividends starting in 4 years of $1, growing 4% annually. That value is $11.56.

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61 views2 pages

Untitled

The document contains three investment scenarios: 1) A risky bond that defaults after 3 years, paying the bondholder $150. The realized return is 37.34%. 2) The same bond, but the firm does better and pays all promised interest and principal over 10 years. The realized return is 22.42%. 3) An analyst estimates a stock will pay dividends starting in 2 years of $1, growing 6% annually. The stock is valued at $15.14. A second analyst estimates dividends starting in 4 years of $1, growing 4% annually. That value is $11.56.

Uploaded by

Wanda Dada
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as TXT, PDF, TXT or read online on Scribd
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Default Risk (Default risk) You buy a very risky bond that promises to a 9.

5% coupon and retu rn 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? Present Value (PV) = $500 Coupon rate = 9.5% Par Value = $1,000 Maturity = 3.5 years Future Value (FV) = -$1,000 Realized return Investment rate = 37.34% b. The firm does far better than expected and bondholders receive all of the pro mised interest and principal payments. What is the realized return on your investment? Present Value (PV) = $500 Coupon rate = 9.5% Par Value = $1,000 Maturity = 10 years Yearly Coupon Payment (PMT) = $1,000 x .95 = -95 PV = $500 FV = -1,000 Realized Rate of Return = 0.2242 Realized Return on Investment = 22.42% Chapter 5: Problem B20 Constant Growth Model (Constant growth model) Medtrans is a profitable firm that is to paying a divide nd 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 colleagu es at the same firm, is less optimistic. Bret thinks that Medtrans will begin pa ying 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? Paid dividend (PD) for 2 years = $1 Growth Rate (g) of dividend = 6% Required rate of return (R) = 13% Medtrans Stock Value (P2) = D3 / (R-g) (P2) = D2 (1+g) / (0.13 0.06) (P2) = 1.00 (1.06) / 0.07 = 15.14287 = 1.06 / 0.07 = $15.14 b. What value would Bret assign to the Medtrans stock? Medtrans Stock Value (P4) = D5 / (R-g) (P4) = D5 (1+g) / (0.13 0.04) (P4) = 1.00 (1.04) / 0.09 = 1.04 / 0.09 = $11.555 = $11.56 Chapter 7: Problem C1 Beta and Required Return (Beta and required return) The riskless return is currently 6%, and Chicago Gear has estimated the contingent returns given here.

a. Calculate the expected returns on the stock market and on Chicago Gear stock. Expected Return on Stock Market = (0.20 x -0.10) + (0.35 x 0.10) + (0.30 x 0.15) + (0.15 x 0.25) = (-0.02 + 0.035 + 0.045 + 0.0375) = 0.0975 Expected Return on Stock Market = 9.75% Expected Return on Chicago Gear Stock = (0.20 x -0.15) + (0.35 x 0.15) + (0.30 x 0.25) + (0.15 x 0.35) = (-0.03 + 0.0525 + 0.075 + 0.0525) = 0.15 Expected Return on Chicago Gear Stock = 15% b. What is Chicago Gears beta? Realized Average Return on Chicago Gear = (-0.15 + 0.15 + 0.25 + 0.35) / 4 = 0.1 5 Expected Return on Chicago Gear = 15% Rf = Risk-free Return = 6% = Beta 0.06 + Beta () x (0.15 - 0.06) = 0.15 0.15 = 0.06 + x 0.09 0.15 - 0.06 = 0.06 0.06 + x 0.09 0.15 - 0.06 = x 0.09 0.09 = x 0.09 x 0.09 = 0.09 = 0.09 / 0.09 0.09/0.09 = 1 Chicago Gears = 1

c. What is Chicago Gears required according to the CAPM?

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