Problem One [15 Marks]:
A) What is the relationship between the current yield and YTM for premium bonds? For discount bonds? For bonds selling at par value. [4 Marks]
B) Investors who purchased bonds several years ago enjoyed double digit yields. These same investors today are complaining loudly about the current low single digit returns. Are investors that much worse off today? Explain what investors should be considering and how to determine whether they are better off or worse off today than they were several years ago. [5 Marks]
C) TIM Bond and CAP Bond are very popular in Canada. TIM Bond is a 3% coupon bond. CAP Bond is a 9% coupon bond. Both bonds have 15 years to maturity, make semi-annual payments and have a YTM of 6%. If interest rates suddenly rise by 2%, what is the percentage price change of these bonds? What if rates suddenly fall by 2% instead? What does this problem tell you about the interest rate risk of lower coupon bonds? [6 Marks]
Problem Two [15 Marks] :
- Marco Inc. is experiencing rapid growth. Dividends are expected to grow at 30% per year during the next three years, 20% over the following year, and then 6% per year indefinitely. The required return on this stock is 10%, and the stock currently sells for $76 per share. What is the projected dividend for the coming year? [7 Marks]
B) Consider four different stocks, all of which have a required return of 17% and a most recent dividend of $4.50 per share. Stocks W, X, and Y are expected to maintain constant growth rates in dividends for the foreseeable future of 10%, 0%, and 25% per year, respectively. Stock Z is a growth stock that will increase its dividend by 20% for the next two years and then maintain a constant 12% growth rate thereafter. What is the dividend yield for each of these four stocks? What is the expected capital gains yield? Discuss the relationship between the various returns that you find for each of these stocks. [8 Marks]
Problem Three [15 Marks]:
- For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak form efficient, (2) the market is weak form but not semi-strong form efficient, (3) the market is semi-strong form but not strong form efficient, and (4) the market is strong form efficient. [9 Marks]
- The stock price has risen steadily each day for the past 30 days.
- The financial statements for a company were released three days ago, and you believe you’ve uncovered some anomalies in the company’s inventory and cost control reporting techniques that are causing the firms true liquidity strength to be understated.
You observe that the senior management of a company has been buying a lot of the company’s stock on the open market over the past week.
- You find a certain stock that had returns of 9%, -16%, 21%, and 17% for the four of the last five years. If the average return of the stock over this period was 10.3%, what was the stock’s return for the missing year? What is the standard deviation of the stock’s return? [6 Marks]
Problem Four [15 Marks]:
- We routinely assume that investors are risk-averse return-seekers, i.e., they like returns and dislike risk. If so, why do we contend that only systematic risk is important? (Alternatively, why is total risk not important to investors, in and of itself?) [5 Marks]
- Mustard Patch Doll Company needs to purchase new plastic moulding machines to meet the demand for its product. The cost of the equipment is $100,000. It is estimated that the firm will increase operating cash flow (OCF) by $22,000 annually for the next seven years. The firm is financed with 40% debt and 60% equity, both based on market values. The firm’s cost of equity is 16% and its pre-tax cost of debt is 8%. The flotation costs of debt and equity are 2% and 8%, respectively. Assume the firm’s tax rate is 34%. [10 Marks]
(i) What is the firm’s WACC?
(ii) Ignoring flotation costs, what is the NPV of the proposed project?
(iii) What is the weighted average flotation cost, fA, for the firm?
(iv) What is the dollar flotation cost of the proposed financing?
(v) After considering flotation costs, what is the NPV of the proposed project?