MINI CASE

Gina and Tom Harrison are married, and both are in their mid-30s. Up until now, they have been spending most of their $70,000 joint income on what they considered to be necessities: a down payment for their new home, home furnishings, two new cars, water ski equipment, and a new ski boat. Their New Years' resolution was to begin saving for their retirement. While the Harrisons have not thought twice about spending money, they have been very conservative with the little money they have managed to save. Over the years, they have saved $20,000 which is now invested in a certificate of deposit at their local bank. With one-year CDS yielding below 5 percent, the Harrisons realize that they need a more aggressive investment strategy if they are ever going to be able to live comfortably in retirement (i.e., maintain their current standard of living). They are interested in investing in both bonds and stocks, but they know very little about their valuation. They have contacted you, an investment advisor with Beranek & Beranek Investments, Inc., to assist them with their investment strategy. You begin the session by discussing the following questions with the Harrisons to familiarize them with bond and stock valuation: a. How is the value of any asset whose value is based on expected future cash flows determined? How is the discount rate determined? ANSWER: The value of an asset is merely the present value of its expected future cash flows:

V0 =

CF1 + CF2 2 + CF3 3 + . . . + CFn n . 0 1 (1 + k ) (1 + k ) (1 + k ) (1 + k )

Note that each period's cash flow could have a different discount rate, but in practice it is common to use a single discount rate for all flows. The discount rate is the opportunity cost of capital, that is, the rate of return that could be obtained on alternative investments of similar risk. Thus, the discount rate depends on (1) the riskiness of the cash flows and (2) the general level of interest rates.

b.

Find the value of a 1-year, $1,000 par value bond with a 12 percent annual coupon if its required rate of return is 12 percent. What is the value of a similar 10-year bond?

ANSWER: A bond has a specific cash flow pattern consisting of a stream of constant interest payments plus the return of par at maturity. For a 1-year, 12 percent annual coupon bond, $1,000 par value bond with a required rate of return of 12 percent, we have this situation: 0
Copyright 1996 by The Dryden Press. All rights reserved.

1
Chapter 4 - 17

120 1,000 Thus, V = $120(PVIFA12%,1) + $1,000(PVIF12%,1) = $1,000. Note that when the required rate of return equals the coupon rate, bonds sell at their par value, so the 10-year bond would also sell at $1,000. The investor receives his or her required return solely in the form of annual interest payments, and then receives the price paid (the par value) at maturity.

c.

What would be the value of the bonds described in Part b if investors required a 15 percent return? A 9 percent return? What would happen to the value of the 10-year bond over time if the required rate of return remained at 15 percent? Remained at 9 percent?

ANSWER: At a 15 percent required return, we have V1-year = $120(PVIFA15%,1) + $1,000(PVIF15%,1) = $973.91 and V10-year = $120(PVIFA15%,10) + $1,000(PVIF15%,10) = $849.44. Alternatively, with your financial calculator input the following to determine the value of the 1-year bond: N=1, I=15, PMT=120, and FV=1,000 to solve for PV=$973.91. To find the value of the 10-year bond just replace N=1 with N=10 to solve for PV=$849.44. Note that when the required rate of return is above the coupon rate, the bonds sell below par, or at a discount. At a 9 percent required return, V1-year = $120(PVIFA9%,1) + $1,000(PVIF9%,1) = $1,027.52. and V10-year = $120(PVIFA9%,10) + $1,000(PVIF9%,10) = $1,192.53. Alternatively, with your financial calculator input the following to determine the value of the 1-year bond: N=1, I=9, PMT=120, and FV=1,000 to solve for PV=$1,027.52. To find the value of the 10-year bond just replace N=1 with N=10 to solve for PV=$1,192.53. When the required rate of return is below the coupon rate, the bonds sell above
Chapter 4 - 18 Copyright 1996 by The Dryden Press. All rights reserved.

par, or at a premium. If interest rates, and hence the required rate of return, remain constant over time, then a bond's value moves toward its par value over time. Thus, the value of a premium bond decreases to $1,000, and the value of a discount bond increases to $1,000 over time. At maturity, the value of any bond must equal its par value (plus accrued interest).
d. What is the yield to maturity on a 10-year, 12 percent annual coupon, $1,000 par value bond that sells for $895.68? That sells for $1,122.89? What is the current yield and capital gains yield in each case?

ANSWER: The yield to maturity (YTM) is that discount rate which equates the present value of a bond's cash flows to its price. In other words, it is the promised rate of return on the bond. On a time line, we have the following situation: 0 -895.68 1 120 9 || 120 10 120 1,000

Or, using present value interest factors: $895.68 = $120(PVIFAk,10) + $1,000(PVIFk,10), where k is the bond's YTM. The best way to solve for k = YTM is to use a financial calculator with a bond valuation capability. Input the following into your financial calculator: N=10, PV=-895.68, PMT=120, FV=1,000, and then solve for I = k = YTM = 14.0%. We know before we even do the calculation that the YTM must be greater than the 12 percent coupon rate because the bond is selling at a discount. Conversely, the bond selling at a premium must have a YTM less than 12 percent. At a price of $1,122.89, k = YTM = 10.0%. The current yield on a bond is the coupon yield expected in the coming year, while a bond's capital gains yield is the coming year's return due to price changes:
Current yield = Annual coupon payment ,0 Current price

Copyright 1996 by The Dryden Press. All rights reserved.

Chapter 4 - 19

and, since YTM = Current yield + Capital gains yield, Capital gains yield = YTM - Current yield. For the 14 percent YTM bond selling at discount, Current yield = $120/$895.68 = 0.1340 = 13.40% and Capital gains yield = 14.00% - 13.40% = 0.60%. The capital gains yield can be easily checked. What is the expected value of the bond in 1 year, that is, what is the value of a 9-year, 12 percent annual coupon bond if its YTM (its required rate of return) is 14.0 percent? The answer, using the bond valuation function of a calculator, is $901.07--the value of a discount bond will increase over time if rates remain constant. Now we can calculate this bond's capital gains yield as
Capital gains yield = ( V1 - V 0 )/ V 0 0 = ($901.07 - $895.68)/$895.68 = 0.0060 = 0.60% .

For the 10 percent YTM bond selling for $1,122.89, Current yield = $120/$1,122.89 = 10.69%, and Capital gains yield = 10.00% - 10.69% = -0.69%.

e.

What's interest rate (price) risk? Which bond in Part b has more interest rate risk, the 1-year bond or the 10-year bond? What's reinvestment rate risk? Which bond in Part b has more reinvestment rate risk, assuming a 10-year investment horizon?

ANSWER: Interest rate risk is the risk that a bond will lose value if interest rates rise. (Note that interest rate risk is also called "price risk.") In Part c, we developed the following values for a 12 percent annual coupon bond: Maturity k 9% 12
Chapter 4 - 20

1-year $1,028 1,000 2.8%

10-year $1,193 1,000

19.3% 0

Copyright 1996 by The Dryden Press. All rights reserved.

15

974

-2.6%

849

- 15.1% 0

A 3 percentage point increase in k causes the value of the 1-year bond to decline by only 2.6 percent, but the 10-year bond declines in value over 15 percent. Thus, the 10-year bond has more interest rate risk. Reinvestment rate risk is the risk that funds must be reinvested in the future at a rate lower than today's rate. To illustrate, suppose you invested in a 1-year bond with a YTM of 12 percent, but your investment horizon was 5 years. Now, after 1 year, you must reinvest the principal and interest for another 4 years. If rates have fallen to 9 percent, your $1,120 principal plus interest rollover will now be yielding only 9 percent. Clearly, buying bonds that have maturities less than the planned investment horizon creates reinvestment rate risk. However, bonds which match the holding period also have reinvestment rate risk related to coupon reinvestment. A bond's YTM implicitly assumes the opportunity to reinvest the coupon payments at the YTM rate. Thus, a 5-year, 12 percent, annual coupon bond which sells at par, and hence has a YTM of 12 percent, will only provide the holder an after-the-fact, or "true," 12 percent return if all coupon payments are reinvested when received at a 12 percent rate. If interest rates rise during the term of the bond, the realized rate of return will be greater than 12 percent, while if interest rates fall, the realized return will be less than 12 percent. Of the two bonds in Part b, the 1-year bond has more reinvestment rate risk because its principal and coupon payment is exposed to this risk, while reinvestment rate risk only applies to the coupon payments on the 10-year bond.

Copyright 1996 by The Dryden Press. All rights reserved.

Chapter 4 - 21

f.

How would your analysis have changed if the bond in parts b and c had paid interest semiannually rather than annually?

ANSWER: In reality, virtually all bonds issued in the United States have semiannual coupons and are valued as shown below: V1-year = $60(PVIFA6%,2) + $1,000(PVIF6%,2) = $1,000.00, and V10-year = $60(PVIFA6%,20) + $1,000(PVIF6%,20) = $1,000.00. At a 15 percent required return, V1-year = $60(PVIFA7.5%,2) + $1,000(PVIF7.5%,2) = $973.07, and V10-year = $60(PVIFA7.5%,20) + $1,000(PVIF7.5%,20) = $847.08. At a 9 percent required return, V1-year = $60(PVIFA4.5%,2) + $1,000(PVIF4.5%,2) = $1,028.09, and V10-year = $60(PVIFA4.5%,20) + $1,000(PVIF4.5%,20) = $1,195.12.

g.

Suppose you could buy, for $1,000, either a 12 percent, 10-year, annual payment bond or a 12 percent, 10-year semiannual payment bond. They are equally risky. Which would you prefer? If $1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond?

ANSWER: The semiannual payment bond would be better. Its EAR would be: 0 An EAR of 12.36% is clearly better than one of 12.0%, which is what the annual payment bond offers. You, and everyone else, would prefer it. If the going rate of interest on semiannual bonds is kNom = 12%, with an EAR of 12.36%, then it would not be appropriate to find the value of the annual
Chapter 4 - 22 Copyright 1996 by The Dryden Press. All rights reserved.

payment bond using a 12% EAR. If the annual payment bond were traded in the market, its value would be found using 12.36%, because investors would insist on getting the same EAR on the two bonds, because their risk is the same. Therefore, you could find the value of the annual payment bond, using 12.36%, with your calculator. semiannual payment bond. Note that, if the annual payment bond were selling for $979.96 in the market, its EAR would be 12.36%. This value can be found by entering N = 10, PV = -979.96, PMT = 120, and FV = 1,000 into a financial calculator and then pressing the k = I button to find the answer 12.36%. With this rate, and the $979.96 price, the annual and semiannual payment bonds would be in equilibrium--investors would receive the same rate of return on either bond, so there would not be a tendency to sell one and buy the other (as there would be if they were both priced at $1,000). It would be $979.96 versus $1,000 for the

h.

What is the value of a perpetual bond with an annual coupon of $120 if its required rate of return is 12 percent? 15 percent? 9 percent? Assess the following statement: "Because perpetual bonds match an infinite investment horizon, they have little interest rate risk."

ANSWER: The value of a perpetuity is simply:

Pmt . Thus, k $120 = $1,000.00. V12% = 0.12 0 $120 = $800.00. V15% = 0.15 $120 = $1,333.33. V 9% = 0.09 V=

Copyright 1996 by The Dryden Press. All rights reserved.

Chapter 4 - 23

Perpetual bonds have the highest interest rate risk of any bonds--their value changes the most as interest rates change. (Refer to the table in answer to Part e.)

I.

Suppose a 10-year, 12 percent, semiannual coupon bond having a par value of $1,000 is currently selling for $1,124.62, and yielding 10 percent to maturity. However, the bond can be called after five years for a price of $1,050. What is the bond's yield to call? If you bought this bond, would you be more likely to earn the YTM or the YTC?

ANSWER: If the bond is called, bondholders would receive $1,050 at the end of Year 5. Thus,
$1,124.62 = $60(PVIFA kd / 2,10 ) + $1,050(PVIFkd / 2,10 ) k d / 2 = 4.8027% kd = YTC = 9.6055%.

Since the coupon rate is 12 percent, kd at present is lower, because the bond is selling at a premium. If interest rates stay at the current level, the bond will surely be called, and investors will earn 9.6055 percent. Thus, investors probably expect 9.6055%, so kd = 9.6055%. In general, investors expect to earn the YTC on premium bonds, but to earn YTM on par and discount bonds.

j.

What is the after-tax YTC on the bond described in Part I to an investor in the 40 percent federal-plus-state tax bracket?

ANSWER: To answer this question, lay out the after-tax cash flows to the investor: (Here we assume that the capital loss is taken in Year 5.)

Chapter 4 - 24

Copyright 1996 by The Dryden Press. All rights reserved.

Year 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5

BT Cash Flow ($1,124.62) 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 1,050.00

AT Cash Flow ($1,124.62) 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 1,079.85*

*Tax savings = ($1,124.62 - $1,050)0.4 = $29.85.

k.

What formula can be used to value any stock, regardless of its dividend pattern? How are constant growth stocks valued? What happens if g > ks? Will many stocks have g > ks?

ANSWER: The value of any stock is the present value of its expected dividend stream:
P0 = D1 D2 D3 D + + +...+ .0 1 2 3 (1 + ks ) (1 + ks ) (1 + ks ) (1 + ks )

However, some stocks have dividend patterns which allow them to be valued using short-cut formulas. A constant growth stock is one whose dividends are assumed to grow at a constant rate forever. Clearly, no real-world stocks fit the constant growth assumption, but companies whose dividends are expected to grow somewhat steadily into the foreseeable future are often valued as constant growth stocks. For a constant growth stock, D1 = D0(1 + g), D2 = D1(1 + g) = D0 (1 + g) , and so on. With this regular dividend pattern, the general stock valuation
Copyright 1996 by The Dryden Press. All rights reserved. Chapter 4 - 25

model can be simplified to

D1 = D0 (1 + g) . 0 P0 = ks - g ks - g

This is the well-known "Gordon," or "constant-growth" model for valuing stocks. Here D1 is the next expected dividend, which is assumed to occur 1 year from now; ks is the required rate of return on the stock; and g is the constant growth rate. The model is derived mathematically, and the derivation requires ks > g. If g is greater than ks, the model gives a negative stock price, which is nonsensical. The model simply cannot be used unless ks > g, g is expected to be constant, and g can reasonably be expected to continue indefinitely. However, it is hard to imagine a stock that is expected to grow forever at a rate that exceeds its required rate of return.

l.

If DLC Corporation's beta coefficient is 1.2, the risk-free rate (yield on Tbonds) is 10 percent, and the required rate of return on the market is 15 percent, what is DLC's required rate of return?

ANSWER: Here we use the SML to calculate DLC's required rate of return: ks = kRF + (kM - kRF)bDLC = 10% + (15% - 10%)(1.2) = 10% + (5%)(1.2) = 10% + 6% = 16.0%. m. DLC's last dividend (D0, which was paid yesterday) was $4.00. The dividend is expected to grow at a constant 6 percent rate. What is the stock's current value? What is the stock's expected value in one year? What is the expected dividend yield and capital gains yield during the first year? What is the expected total return during the first year? ANSWER: Since DLC is a constant growth stock, its dividend grows by a constant 6 percent per year: D0 = $4.00 (already paid). D1 = D0(1.06) = $4.24. 2 D2 = D1(1.06) = D0(1.06) = $4.494. 3 D3 = D2(1.06) = D0(1.06) = $4.764.
Chapter 4 - 26 Copyright 1996 by The Dryden Press. All rights reserved.

DLC's value is estimated using the constant growth model:

P0 = $4.24 $4.24 D1 = = = $42.40. 0 ( ks - g) (0.16 - 0.06) 0.10

After one year, D1 will have been paid, so the expected dividend stream will then be D2, D3, D4, and so on. Thus, the expected value one year from now is
P1 = D2 = $4.494 = $4.494 = $44.94. 0 ( ks - g) (0.16 - 0.06) 0.10

The dividend yield in any year n is

Dividend yield = Dn , 0 Pn - 1

while the capital gains yield is

( - ) Capital gains yield = Pn Pn - 1 . 0 Pn - 1

Thus, the dividend yield in the first year is 10.0 percent, while the capital gains yield is 6.0 percent:
Dividend yield = $4.24 = 0.100 = 10.0%. 0 $42.40

Capital gains yield =

($44.94 - $42.40) $2.54 = = 0.0599 6.0%. 0 $42.40 $42.40

Finally, the total yield, or total return, is the sum of the dividend yield and capital gains yield:
Total yield = Dividend yield + Capital gains yield 0 = 10.0% + 6.0% = 16.0%.

n.

Now assume that DLC's stock is currently selling at $42.40. What is the
Chapter 4 - 27

Copyright 1996 by The Dryden Press. All rights reserved.

expected rate of return on the stock?

ANSWER: The constant growth model can be rearranged to this form:

D1 + g . 0 ks = P0

Here the current price of the stock is known, and we solve for the expected return. (Note that in Part m, the required return was known and we solved for the stock's intrinsic value.) For DLC,
$4.24 ks = $42.40 + 0.060 = 0.100 + 0.060 = 10.0% + 6.0% = 16.0%. 0

Note these points: (1) If a stock is in equilibrium, then its price equals its value required return equals its expected return
( ks = k s ) 0. ( P0 = P0 ) 0

and its

(2) For any stock, the expected total return in any year as seen by a marginal investor must be equal to the dividend yield plus the capital gains yield. (3) For constant growth stocks, the following relationships hold: (a) (b) The dividend yield is constant; that is, D1/P0 = D2/P1 = D3/P2, and so on. The capital gains yield is also constant. Further, the capital gains yield is equal to g, the constant growth rate. For DLC, the dividend yield is a constant 10 percent, while the capital gains yield is g = constant = 6%. (c) The stock price grows at the constant rate g.

o.

What would DLC's stock be worth if its dividends were expected to have zero growth?

ANSWER: If DLC's dividends were not expected to grow at all, then its dividend stream would be a perpetuity: V = Pmt/k.
Chapter 4 - 28 Copyright 1996 by The Dryden Press. All rights reserved.

Also, note that the constant growth model becomes the perpetuity model when g = 0:
D1 D1 D1 = Pmt P0 = ( - g) = ( - 0) = k ks ks ks $4 V= = $25.00. 0.16

Note that many preferred stocks are perpetual, and hence are valued in this way.

p.

Now assume that DLC will experience supernormal growth of 30 percent per year during the next three years and then settle into a constant growth rate of 6 percent. What is its value under these conditions? What is its expected dividend yield and capital gains in Year 1? In Year 4?

ANSWER: DLC is no longer a constant growth stock, so the Gordon (constant growth) model is not applicable. Note, however, that it becomes a constant growth stock in 3 years. Thus, it has a nonconstant growth period followed by permanent constant growth. The easiest way to value nonconstant growth stocks is to value the nonconstant and constant growth periods separately, and then sum these values. and sum them: PV D1 = $5.200/(1.16) = $ 4.483 2 PV D2 = $6.760/(1.16) = 5.024 3 PV D3 = $8.788/(1.16) = 5.630 $15.137 Now, recognize that beginning in Year 4, DLC becomes a constant growth stock. Thus, the Year 4 and all subsequent dividends can be valued by the Gordon model. However, the value we obtain for the constant growth period occurs 1 year before the first constant growth dividend, or at Year 3:
D4 = $9.3153 = $9.3153 = $93.15. 0 P3 = 0.10 ks - g 0.16 - 0.06
1

To begin, place the expected

dividends on a time line. Then, find the PV of each of the first three dividends,

Copyright 1996 by The Dryden Press. All rights reserved.

Chapter 4 - 29

To find the current value of the constant growth dividend stream, we must discount
P3 0 back

to Year 0: $93.153/(1.16) = $59.679.

3

Finally, DLC's value is the sum of the nonconstant and constant growth components:
P0 0 =

$15.14 + $59.68 = $74.82.

The dividend yield in Year 1 is 6.95 percent and the capital gains yield is 9.05 percent:
$5.200 = 0.0695 = 6.95%. 0 $74.82 Capital gains yield = 16.00% - 6.95% = 9.05%. Dividend yield =

As a check, we can find

P1 0:

P1 = PV D2 + PV D3 + PV P3 0 $6.760 $8.788 $93.15 = + + = $81.584. 1 2 2 (1.16 ) (1.16 ) (1.16 )

Thus,
- Capital gains yield = P1 P0 P0 0 $81.584 - $74.820 $6.764 = = 0.0905 = 9.05%. $74.820 $74.820

Note that during the nonconstant growth period, the dividend yields and capital gains yields are not constant, and the capital gains yield does not equal g. However, the total return in each year must still equal the required rate of return when the stock is in equilibrium, and hence
ks = Dividend yield + Capital gains yield = ks . 0

At Year 4, the stock becomes a constant growth stock, and hence g = Capital gains yield = 6.0% and Dividend yield = 16.0% - 6.0% = 10.0%.

q.

Suppose DLC is expected to experience no growth during the first three years and then to grow at a constant 6 percent rate. What is the stock's

Chapter 4 - 30

Copyright 1996 by The Dryden Press. All rights reserved.

value now? ANSWER: Now we have this situation: 0

g = 0% 0

g = 0% 0

g = 0% 0

g = 6% 0

$4.000

$4.000

$4.000

$4.000
1

$4.240

PV D1 = $4.000/(1.16) = $3.448 2 PV D2 = $4.000/(1.16) = 2.973 3 PV D3 = $4.000/(1.16) = 2.563 $8.984

$4.240 P3 = 0.10 = $42.40. $42.40 PV P3 = = $27.164. (1.16 )3 P0 = $8.984 + $27.164 = $36.148.

During Year 1,
Dividend yield = $4.000 = 0.1107 = 11.07%. 0 $36.148

Capital gains yield = 16.00% - 11.07% = 4.93%. 0

As a check,
$4.00 $4.00 $42.40 + + = $37.931. 0 1 (1.16 ) (1.16 )2 (1.16 )2

P1 =

Capital gains yield =

$37.931 - $36.148 = 0.0493 = 4.93%. 0 $36.148

r.

Finally, assume that DLC's dividends are expected to decline at a constant rate of 6 percent. Would anyone buy the stock, and if so, at what price? If you bought the stock, what dividend yield would you expect?

ANSWER:

This is a constant growth situation, but with negative growth:

Chapter 4 - 31

Copyright 1996 by The Dryden Press. All rights reserved.

D1 = D0 (1 + g) = $4.00(0.94) = $3.76 = $17.09. 0 P0 = 0.16 - (- 0.06) 0.22 ks - g ks - g

Since it is a constant growth stock,

g = Capital gains yield = - 6.0%, 0

and hence
Dividend yield = 16.0% - (- 6.0%) = 22.0%. 0

As a check,
Dividend yield = $3.76 = 0.220 = 22.0%. 0 $17.09

The dividend and capital gains yields are constant over time, but a high (22.0 percent) dividend yield is needed to offset the negative capital gains yield.

Chapter 4 - 32

Copyright 1996 by The Dryden Press. All rights reserved.