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Bond and Stock Valuation Practice Problems and Solutions

Financial Management Ii (Wichita State University)

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Finance 440
Review: Bond and Stock Valuation
Practice Problems

Multiple Choice

1. Which of the following statements is correct regarding bonds and bond ratings?
A. The yield-to-maturity of a bond with an investment-grade rating will generally be higher than
the yield-to-maturity of a bond with a speculative-grade rating.
B. The yield-to-maturity of a bond with an investment-grade rating will generally be lower than
the yield-to-maturity of a bond with a speculative-grade rating.
C. The yield-to-maturity of a bond with an investment-grade rating will generally be equal to the
yield-to-maturity of a bond with a speculative-grade rating.
D. There is no relationship between the default risk of a bond and its yield-to-maturity.
E. Bonds with investment-grade ratings are considered more risky than bonds with speculative-
grade ratings.
F. Both A and E are correct.

ANS: B

2. According to the constant growth valuation model (sometimes called the Gordon Growth
Model) the value of a share of common stock depends on:
A. The required rate of return that investors demand on the common stock.
B. The expected growth rate of dividends paid to preferred stockholders.
C. The standard deviation of the firm’s past common stock returns.
D. All of the above are correct.

ANS: A

3. Which of the following statements is FALSE regarding bonds?

A. If the par value is lower than the market price, then the yield-to-maturity must be lower than
the coupon rate.
B. If the market price is lower than the par value, then the coupon rate must be lower than the
yield-to-maturity.
C. If the bond sells at a premium, then the coupon rate must be higher than the yield-to-maturity.
D. Both A and B are false.
E. None of the above are false.

ANS: E

4. Which statement about common stockholders is incorrect?

A. Common stockholders have a residual claim on the firm’s cash flows.

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B. Common stockholders have first claim on the firm’s assets during bankruptcy
C. Common stockholders have a voting right.
D. Common stockholders are the ultimate owners of a corporation.
ANS: B

5. In theory, the value of a financial asset

A. is based upon the cash flows provided by the asset in prior years.
B. equals the cash flows that the asset will provide the owner of the asset this year.
C. equals the present value of expected future cash flows accruing to the asset’s owner.
D. None of the above
ANS: C

6. A bond’s coupon rate

A. equals its annual coupon payment divided by the bonds’ current market price.
B. varies during the life of the bond.
C. equals its annual coupon payment divided by the interest rate
D. equals its annual coupon payment divided by its par value.
E. both a and b are correct.

ANS: D

Problems
*Note: P1 through P5 deal with bond valuation. P6 through P11 deal with stock valuation.

P1. Bennifer Jewelers just issued ten-year bonds that make annual coupon payments of $50. Suppose
you purchased one of these bonds at par value ($1,000) when it was issued. Right after your
purchase, market interest rates jumped, and the YTM (interest rate) on your bond rose to six
percent. What is the new price of you bond?
50 50 50 1,050
A1. P  2
 3
 ....  10
$926.40 so the price fell by $73.60.
1.06 1.06 1.06 1.06

Calculator

N = 10, I/Y = 6, PMT = 50, FV = 1,000  PV = 926.40 (ignore negative sign)

P2. A $1,000 par value bond makes annual coupon payment of $75. If it offers a yield to maturity of
7.5 percent, what is the price of the bond?

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A2. The bond will sell at par value, i.e., it’s price is $1,000 because the bond’s coupon rate (75/1000
= 7.5%) is equal to its YTM. The idea here is that a bond’s market price equals par value if the
yield to maturity is equal to the bond’s coupon rate.

P3. A bond makes annual coupon payments of $75. The bond matures in four years, has a par value
of $1,000, and sells for $975.30. What is the bond’s yield to maturity (YTM)?

A3. This is what the problem looks like mathematically.

75 75 75 1,075
975.30   2
 3

1  r (1  r ) (1  r ) (1  r ) 4

You should use the financial calculator to solve for r, the YTM, unless you want to undertake a costly
trial and error process.

Calculator:
N = 4, PV = 975.3, PMT = 75, FV = 1,000 I/Y = 8.25% (this is the YTM)

P4. A bond offers a six percent coupon rate and currently sells at par. What is the bond’s yield to
maturity?

A4. If a bond is selling at par (its current market price is equal to the par value), then the bond’s yield
to maturity must be equal to the coupon rate. Therefore, the YTM is 6% .

P5. 5 years ago, you purchased a corporate bond for $942.41. At the time, the bond had a YTM of
10% and 9 years left to maturity. Today, the YTM on your bond is 8%. With this information,
can you calculate the current market price of your bond? Assume fixed annual coupon payments
and a par value of $1,000.

A5. We know that the current YTM is 8% and the par value is $1,000. We have not explicitly been
given the time to maturity today, nor have we been given the coupon payment. If we can use the
information given in the problem to infer the coupon payment and time to maturity, then we will
have everything we need to solve for the current price of the bond. 5 years ago, the bond had 9
years left to maturity, a YTM of 10%, a price of $942.41, and the par value was the same as it is
today, $1,000. Using this information, we can solve for the coupon payment on the calculator as
follows:
N=9

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I/Y=10
PV= -942.41
FV= 1,000
Solve for PMT = 90 : So the annual coupon payment is $90

5 years ago, the bond had 9 years left to maturity. This implies that, today, the bond currently has
4 years left to maturity. Using this info, along with the current YTM of 8%, the par value of
1,000, and the coupon payment of 90, we can solve for the bond price as follows:
N=4
I/Y=8
PMT=90
FV= 1000
Solve for PV = -1,033.12 : So the current price of the bond is $1,033.12

P6. Argaiv Towers has an outstanding issue of preferred stock that pays an $8 dividend annually. If
the required return on Argaiv preferred stock is 6 six percent, and if Argaiv pays its next dividend
in one year, what is the market price of the preferred stock today?

A6. We always value preferred stock as a perpetuity, where the payments are all the same (zero
growth).

P0 = $8/0.06 = $133.33

P7. Artivel Mining Corp.’s preferred stock pays a dividend of $5 each year. If the stock sells for $40
and the next dividend will be paid in one year, what return do investors require on Artivel
preferred stock?

A7. $5/r = $40

r = 12.5%

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P8. The C. Alice Stone Company’s preferred stock pays a $10 dividend every year, with the next
dividend due in one year. Investors require a 10% return on this preferred stock. What is its
current market price? What will the price be immediately after the next dividend payment (P 1 ) if
the required rate of return does not change?

A8. P0 = $10/0.0.1 = $100 is the current price. A soon as next year’s dividend payment (D 1) is made,
another $10 dividend (D2) is due a year later after that. So next year’s price is P 1=D2/r = 10/0.1 =
100. So next year’s price is also $100. There is no expected appreciation in the price. The entire
10% return comes from the dividend payment.

P9. Propulsion Sciences’ (PS) stock dividend has grown at 10 percent per year for as long as anyone
can remember. Investors believe that a year from now the company will pay a dividend of $3 and
that dividends will continue their 10 percent growth indefinitely. If the market’s required return
on PS stock is 12 percent, what does the stock sell for today, and how much will it sell for a year
from today after the stockholders receive their dividend?

A9. The price today is $3/(0.12-0.10) = $150. A year from now the $3 dividend will be history, with
the next dividend in the sequence of $3.30 expected a year later. This means the stock price just
after the $3 dividend payment should be $3.30/(0.12-0.10) = $165. Notice that this represents a
10 percent growth in the stock price, exactly matching the 10 percent increase in the dividend.

P10. Investors believe that a certain stock will pay a $4 dividend next year. The market price of the
stock is $66.67, and investors expect a 12 percent return on the stock. What long-run growth rate
in dividends is consistent with the current price of the stock?

A10. $66.67 = $4/(0.12-g)

g = 0.06 or 6%

P11. Petscan Radiology’s stock pays a dividend once each year, and it just paid a dividend of $0.85
yesterday. The current market price of the stock is $12.14. If investors believe that Petscan will
increase it dividends by 7 percent per year forever, what is the required rate of return on Petscan’s
stock?

A11. The constant growth valuation formula is:

P0= D1/(r-g)
g=0.13
P0=12.14

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D1 is the dividend investors expect to be paid one year from now, not yesterday’s dividend. Since
dividends are expected to grow at 7% per year, we have:
D1 = 1.07*(0.85) = $0.9095
Plug this into the valuation formula and solve for r:
$0.9095/(r – 0.07) =12.14
r = (0.9095 + 0.07*12.14) / 12.14 = 0.145 or 14.5%

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