Chapter 8

P8.1 An investor in Amman, Jordan, estimates that next year’s sales for Amman Intercontinental Hotels, Inc.
would amount to about 100 million Jordanian dinar. The company has 5 million shares outstanding, generates
a net profit margin of about 10%, and has a payout ratio of 40%. All figures are expected to hold for next year.
Given this information, compute the following:
a. Estimated net earnings for next year

b. Next year’s dividends per share

c. The expected price of the stock (assuming the P/E ratio is 24.5 times earnings)

d. The expected holding period return (latest stock price: 40 Jordanian dinar per share)
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P8.2 Taurus Corp. had sales of $55 million in 2016 and is expected to have sales of $83,650,000 for 2017.
The company’s net profit margin was 5% in 2016 and is expected to increase to 8% by 2017. Estimate the
company’s net profit for 2017.

P8.3 Sirius Lawnmower Co. has total equity of $600 million and 125 million shares outstanding. Its ROE is
18%. Calculate the company’s EPS.

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P8.5 HighTeck has an ROE of 15%. Its earnings per share are $2.00, and its dividends per share are $0.20.
Estimate HighTeck’s growth rate.

P8.6 Last year, Black Hole Company paid $90 million of interest expense, and its average rate of interest for
the year was 15%. The company’s ROE is 20%, and it pays no dividends. Estimate next year’s interest
expense, assuming that interest rates will fall by 20% and the company keeps a constant equity multiplier of
25%.

P8.9 Investors expect that Amalgamated Aircraft Parts, Inc., will pay a dividend of $2.50 in the coming year.
Investors require a 12% rate of return on the company’s shares, and they expect dividends to grow at 7% per
year. Using the dividend valuation model, find the intrinsic value of the company’s common shares.

P8.10 Danny is considering a stock purchase. The stock pays a constant annual dividend of $2.00 per share
and is currently trading at $20. Danny’s required rate of return for this stock is 12%. Should he buy this stock?

P8.11 Larry and Curley are brothers. They’re both serious investors, but they have different approaches to
valuing stocks. Larry, the older brother, likes to use the dividend valuation model. Curley prefers the free cash
flow to equity valuation model.

As it turns out, right now, both of them are looking at the same stock—American Home Care Products, Inc.
(AHCP). The company has been listed on the NYSE for over 50 years and is widely regarded as a mature,
rock-solid, dividend-paying stock. The brothers have gathered the following information about AHCP’s stock:
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 Current dividend (D0) = $2.40/share
Current free cash flow (FCF0)= $1.0 million
Expected growth rate of dividends and cash flows(g)equals= 8%
Required rate of return (r)equals= 14%
Shares outstanding = 350,000 shares
How would Larry and Curley each value this stock?

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P8.13 Let’s assume that you’re thinking about buying stock in West Coast Electronics. So far in your analysis,
you’ve uncovered the following information: The stock pays annual dividends of $5.00 a share indefinitely. It
trades at a P/E of 10 times earnings and has a beta of 1.2. In addition, you plan on using a risk-free rate of 3%
in the CAPM, along with a market return of 10%. You would like to hold the stock for three years, at the end of
which time you think EPS will be $7 a share. Given that the stock currently trades at $62, use the IRR
approach to find this security’s expected return. Now use the dividend valuation model (with constant
dividends) to put a price on this stock. Does this look like a good investment to you? Explain.
Answer:
Required Ret = Rf + Beta ( Rm - Rf )
Rf = Risk free Rate
Beta = Systematic Risk
Rm = Market ret
Required Ret = Rf + Beta ( Rm - Rf ) = 3% + 1.2 (10% - 3%) = 3% + 1.2(7%) = 3% +8.4% = 11.4%

Price after 3 Years = EPS3 * P/E ratio = $ 7 * 10 = $ 70

IRR = rate at which least +ve NPV + [ NPV at that Rate / CHnage in NPV due to 1% inc in DIsc Rate ] * 1%
= 11% + [ 1.40 / 1.57 ] * 1% = 11.89%

IRR > Required Ret, Hence it is good Investment.

P8.17 New Millenium Company earned $2.3 million in net income last year. It took depreciation deductions of
$290,000 and made new investments in working capital and fixed assets of $96,000 and $360.000, respectively.

A. What was New Millenniums Free cash flow last year.

B. Suppose that the company's free cash flow is expected to grow at 4% per year forever. If investors require a
return of 9% on Millennium stock, what is the present value of Millenium's Future free cash flows?

C. New Millennium has 3.5 million shares of common stock outstanding. What is the per share value of the
company's common stock.
d. What is the company's P/E ratio based on last year's earnings (i.e., trailing earnings)?
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e. What is the company's P/E ratio based on next year's earnings (assuming that earnings grow at the same rate as
free cash flow).

P8.18 A particular company currently has sales of $250 million; sales are expected to grow by 20% next year
(year 1). For the year after next (year 2), the growth rate in sales is expected to equal 10%. Over each of the
next two years, the company is expected to have a net profit margin of 8% and a payout ratio of 50% and to
maintain the common stock outstanding at 15 million shares. The stock always trades at a P/E of 15 times
earnings, and the investor has a required rate of return of 20%. Given this information,

a. Find the stock’s intrinsic value (its justified price).

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b. Use the IRR approach to determine the stock’s expected return, given that it is currently trading at $15 per
share.

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c. Find the holding period returns for this stock for year 1 and for year 2.

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P8.19 Assume a major investment service has just given Oasis Electronics its highest investment rating,
along with a strong buy recommendation. As a result, you decide to take a look for yourself and to place a
value on the company’s stock. Here’s what you find: This year Oasis paid its stockholders an annual dividend
of $3 a share, but because of its high rate of growth in earnings, its dividends are expected to grow at the rate
of 12% a year for the next four years and then to level out at 9% a year. So far, you’ve learned that the stock
has a beta of 1.80, the riskfree rate of return is 5%, and the expected return on the market is 11%. Using the
CAPM to find the required rate of return, put a value on this stock.

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P8.20 Consolidated Software doesn’t currently pay any dividends but is expected to start doing so in four
years. That is, Consolidated will go three more years without paying dividends and then is expected to pay its
first dividend (of $3 per share) in the fourth year. Once the company starts paying dividends, it’s expected to
continue to do so. The company is expected to have a dividend payout ratio of 40% and to maintain a return
on equity of 20%. Based on the DVM, and given a required rate of return of 15%, what is the maximum price
you should be willing to pay for this stock today?

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P8.21 Assume you obtain the following information about a certain company:

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Use the constant-growth DVM to place a value on this company’s stock.

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P8.22 You’re thinking about buying some stock in Affiliated Computer Corporation and want to use the P/E
approach to value the shares. You’ve estimated that next year’s earnings should come in at about $4.00 a
share. In addition, although the stock normally trades at a relative P/E of 1.15 times the market, you believe
that the relative P/E will rise to 1.25, whereas the market P/E should be around 18.5 times earnings. Given this
information, what is the maximum price you should be willing to pay for this stock? If you buy this stock today
at $87.50, what rate of return will you earn over the next 12 months if the price of the stock rises to $110.00 by
the end of the year? (Assume that the stock doesn’t pay dividends.)

P8.23 AviBank Plastics generated an EPS of $2.75 over the last 12 months. The company’s earn- ings are
expected to grow by 25% next year, and because there will be no significant change in the number of shares
outstanding, EPS should grow at about the same rate. You feel the stock should trade at a P/E of around 30
times earnings. Use the P/E approach to set a value on this stock.

Value of Stock = Earnings per Share*P/E Ratio

Expected Earnings per share = 2.75*(1.25) = 3.4375

Hence, value of stock = 3.4375*30 = $103.125

P8.25 World Wide Web Wares (4W, for short) is an online retailer of small kitchen appliances and utensils.
The firm has been around for a few years and has created a nice market niche for itself. In fact, it actually
turned a profit last year, albeit a fairly small one. After doing some basic research on the company, you’ve
decided to take a closer look. You plan to use the price-to-sales ratio to value the stock, and you have
collected P/S multiples on the following Internet retailer stocks:

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Find the average P/S ratio for these three firms. Given that 4W is expected to generate $40 million in sales
next year and will have 10 million shares of stock outstanding, use the average P/S ratio you computed above
to put a value on 4W’s stock

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CP1 Chris Norton is a young Hollywood writer who is well on his way to television superstardom. After writing
several successful television specials, he was recently named the head writer for one of TV’s top-rated
sitcoms. Chris fully realizes that his business is a fickle one, and on the advice of his dad and manager, he has
decided to set up an investment program. Chris will earn about a half-million dollars this year. Because of his
age, income level, and desire to get as big a bang as possible from his investment dollars, he has decided to
invest in speculative, high-growth stocks.

Chris is currently working with a respected Beverly Hills broker and is in the process of building up a diversified
portfolio of speculative stocks. The broker recently sent him information on a hot new issue. She advised Chris
to study the numbers and, if he likes them, to buy as many as 1,000 shares of the stock. Among other things,
corporate sales for the next three years have been forecasted as follows:

The firm has 2.5 million shares of common stock outstanding. They are
currently being traded at $70 a share and pay no dividends. The
company has a net profit rate of 20%, and its stock has been trading at
a P/E of around 40 times earnings. All these operating characteristics
are expected to hold in the future.

a. Looking first at the stock:

1. Compute the company’s net profits and EPS for each of the next 3 years.

2. Compute the price of the stock three years from

now.

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 3. Assuming that all expectations hold up and that Chris buys the stock at $70, determine his expected return
on this investment.

4. What risks is he facing by buying this stock? Be specific.

5. Should he consider the stock a worthwhile investment candidate? Explain.

b. Looking at Chris’s investment program in general:

1. What do you think of his investment program? What do you see as its strengths and weaknesses?

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 2. Are there any suggestions you would make?

3. Do you think Chris should consider adding foreign stocks to his portfolio? Explain

CP2. Marc Dodier is a recent university graduate and a security analyst with the Kansas City
brokerage firm of Lippman, Brickbats, and Shaft. Marc has been following one of the hottest issues
on Wall Street, C&I Medical Supplies, a company that has turned in an outstanding performance
lately and, even more important, has exhibited excellent growth potential. It has five million shares
outstanding and pays a nominal annual dividend of $0.05 per share. Marc has decided to take a
closer look at C&I to assess its investment potential. Assume the company’s sales for the past five
years have been as follows:

Marc is concerned with the future prospects of the company, not its past. As a result, he pores over
the numbers and generates the following estimates of future performance:

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a. Determine the average annual rate of growth in sales over the past five years. (Assume sales in
2011 amounted to $7.5 million.)

1. Use this average growth rate to forecast revenues for next year (2017) and the year after that (2018).

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2. Now determine the company’s net earnings and EPS for each of the next two years (2017 and 2018).

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 3. Finally, determine the expected future price of the stock at the end of this two-year period.

b. Because of several intrinsic and market factors, Marc feels that 25% is a viable figure to use for a
desired rate of return.

1. Using the 25% rate of return and the forecasted figures you came up with in question a, compute the
stock’s justified price.

2. If C&I is currently trading at $32.50 per share, should Marc consider the stock a worth while investment
candidate? Explain.

Chapter 11

P11.1 You are considering the purchase of a $1,000 par value bond with an 6.5% coupon rate (with interest
paid semiannually) that matures in 12 years. If the bond is priced to provide a required return of 8%, what is
the bond’s current price?

Price of bond is calculated using the PV function in Excel with these inputs :

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rate = 8% / 2 (annual yield converted to semiannual yield)

nper = 12 * 2 (12 years to maturity with 2 semiannual coupon payments each year)

pmt = 1,000 * 6.5% / 2 (semiannual coupon payment = face value * coupon rate / 2)

fv = 1,000 (face value of bond receivable on maturity)

PV is calculated to be $885.65

P11.2 Two bonds have par values of $1,000. One is a 5%, 15-year bond priced to yield 8%. The other is a
7.5%, 20-year bond priced to yield 6%. Which of these has the lower price? (Assume annual compounding in
both cases.)

Price of bond 1 is calculated using the PV function in Excel with these inputs :

rate = 8% (annual yield)

nper = 15 (15 years to maturity)

pmt = 1,000 * 5% (annual coupon payment = face value * coupon rate)

fv = 1,000 (face value of bond receivable on maturity)

PV is calculated to be $743.22

price of bond 2 is calculated using the PV function in Excel with these inputs :

rate = 6% (annual yield)

nper = 20 (15 years to maturity)

pmt = 1,000 * 7.5% (annual coupon payment = face value * coupon rate)

fv = 1,000 (face value of bond receivable on maturity)

PV is calculated to be $1,172.05

the price of bond 1 is lower

P11.3 Using semiannual compounding, find the prices of the following bonds.

a. A 10.5%, 15-year bond priced to yield 8%

b. A 7%, 10-year bond priced to yield 8%

c. A 12%, 20-year bond priced at 10%

Repeat the problem using annual compounding. Then comment on the differences you found in the prices of
the bonds.

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P11.4 You have the opportunity to purchase a 25-year, $1,000 par value bond that has an annual coupon rate
of 9%. If you require a YTM of 7.6%, how much is the bond worth to you?
ANSWER:
Given: n = 25 years
par = $1000
Coupon rate = 9%
ytm = 7.6%

price of bond formula:

answer: 1154.70

P11.5 A $1,000 par value bond that has a current price of $950 and a maturity value of $1,000 matures in
three years. If interest is paid annually and the bond is priced to yield 9%, what is the bond’s annual coupon
rate?
ANSWER:
n n
Price = Coupon * [1 - 1 / (1 + r) ] / r + FV / (1 + r)

3 3
950 = Coupon * [1 - 1 / (1 + 0.09) ] / 0.09 + 1000 / (1 + 0.09)

950 = Coupon * 2.53129 + 772.18348

Coupon = $70.25

Annual coupon rate = (70.25 / 1000) * 100

Annual coupon rate = 7.025%.

P11.7 Ziad purchases a Treasury bond at E£900 (Egyptian pound). The Treasury bond has a par value of
E£1,000, coupon interest rate of 12%, pays semiannual interest, and has 10 years to maturity. Ziad decides to
hold the bond for the next four years and anticipates that its selling price at the end of four years will be
E£1,120. Calculate the expected annual rate of return (realized) during the holding period.

P11.8 A bond is priced in the market at $920 and has a coupon of 7%. Calculate the bond’s current yield.

Coupon = 0.07 * 1000 = 70

current yield = (Annual coupon / price) * 100

current yield = (70 / 920) * 100

current yield = 7.61%

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P11.6 A 10-year bond has a coupon of 8% and is priced to yield 7%. Calculate the price per $1,000 par value
using semiannual compounding. If an investor purchases this bond three months before a scheduled coupon
payment, how much accrued interest must be paid to the seller?

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P11.9 A $1,000 par value bond with a 7.25% coupon rate (semiannual interest) matures in seven years and
currently sells for $987. What is the bond’s yield to maturity and bond equivalent yield?
Answer:

Par Value = 1,000

Coupon = 7.25%, Semi annual coupon = 36.25

Current Market Price of bond = 987

Since the Bond price is less than the face value of the bond, the YTM would be more than 7.25%

@4%, 36.25 * PVAF(4%, 14) + 1,000 * PVF(4%,14) = 36.25 * 10.563 + 1,000 * 0.577 = 960.39

@3%, 36.25 * PVAF(3%, 14) + 1,000 * PVF(3%,14) = 36.25 * 11.296 + 1,000 * 0.661 = 1,070.60

Now Interpolation,

3% + ((1,070.60 - 987) / (1,070.60 - 960.39)) = 3.76%

Hence YTM = 3.76% * 2 = 7.52%

b. Bond Equivalnet Yield = (Par Value - Current Price of the bond) / Current Price of the bond) * 365 / days to
maturity

Bond Equivalnet Yield = (1,000 - 987) / 987) * 365 / 2,555 (7 * 365 = 2,555)

Hence bond euivalent yield = 0.19%

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P11.10 What is the current yield for a $1,000 par value bond that pays interest semiannually, has nine years
to maturity, and is currently selling for $937 with a bond equivalent yield of 12%?

P11.11 An investor is considering the purchase of an 8%, 18-year corporate bond that’s being priced to yield
10%. She thinks that in a year, this bond will be priced in the market to yield 9%. Using annual compounding,
find the price of the bond today and in one year. Next, find the holding period return on this investment,
assuming that the investor’s expectations are borne out.

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P11.12 You notice in the WSJ a bond that is currently selling in the market for $1,070 with a coupon of 11%
and a 20-year maturity. Using annual compounding, calculate the promised yield on this bond.

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P11.13 A bond is currently selling in the market for $928.62. It has a coupon of 10% and a 10-year maturity.
Using annual compounding, calculate the yield to maturity on this bond.

P11.14 Compute the current yield of an 8%, 10-year bond that is currently priced in the market at $1,100. Use
annual compounding to find the promised yield on this bond. Repeat the promised yield calculation, but this
time use semiannual compounding to find yield to maturity.

current yield = 80/1100 = 7.27%

N = 10, FV = 1000, PV = -1100, PMT = 80

use rate function in Excel

yield to maturity = 6.60%

N = 20, FV = 1000, PV = -1100, PMT = 40

semi annual yield = 3.3085%

annual yield = (1 + 3.3085%)^2 - 1 = 6.73%

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P11.15 You are evaluating an outstanding issue of $1,000 par value bonds with an 8.75% coupon rate that
mature in 25 years and make quarterly interest payments. If the current market price for the bonds is $865,
what is the quoted annual yield to maturity for the bonds?

P11.16 Aziz works for a broker. One of his clients is offered to buy a bond at $1,050. It is a 10%, 15-year bond
with a par value of $1,000 and a call price of $1,100. (The bond’s first call date is in five years.) Coupon
payments are made semiannually.

a. Find the current yield, YTM, and YTC on this issue. Which of these three yields is the highest? Which is the
lowest? Which yield would Aziz use to value this bond? Explain.

b. Assume that the price of the bond declines to $875. Now which yield is the highest? Which is the lowest?
Which yield would Aziz use to value this bond? Explain.

Calculation of Yield to Maturity

YTM = {Annual Interest + (Face value - Market Price)/Maturity date} / (Face value + Market Price)/2

= {100 + (1000 - 1050)/15} / (1000 + 1050)/2 = 9.43 %

Calculation of Yield to Call

YTC = {Annual Interest + (Call Price - Market Price)/First call date} / (Call Price + Market Price)/2

= {100 + (1100 - 1050)/5} / (1100+1050)/2 = 10.23%

Yield to call is highest and Yield to maturity is Lowest.

If market price declines to $875

YTM = {100 + (1000 - 875)/15} / (1000 + 875)/2 = 11.56%

YTC = {100 + (1100 - 875)/5} / (1100+875)/2 = 14.68%

Yield to call is highest and Yield to maturity is Lowest.

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Aziz would use Yield to call to value this bond. As the buyer of a bond usually focuses on its yield to maturity (the
total return that will be paid out by a bond's expiration date). But the buyer of a callable bond also wants to estimate
its yield to call.

A callable bond can be redeemed by its issuer before it reaches its stated maturity date. Callable bonds usually
offer a more attractive yield to maturity, along with the proviso that the issuer may "call" it if overall interest rates
change and it finds it can borrow money less expensively in another way.

P11.17 Assume that an investor is looking at two bonds: Bond A is a 20-year, 9% (semiannual pay) bond that
is priced to yield 10.5%. Bond B is a 20-year, 8% (annual pay) bond that is priced to yield 7.5%. Both bonds
carry 5-year call deferments and call prices (in 5 years) of $1,050.

a. Which bond has the higher current yield?

b. Which bond has the higher YTM?

c. Which bond has the higher YTC?

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C,

P11.18 A zero-coupon bond that matures in 20 years is currently selling for $509 per $1,000 par value. What is
the promised yield on this bond?

Price = 509, N = 20

P11.19 A zero-coupon ($1,000 par value) bond that matures in eight years has a promised yield of 7%. What
is the bond’s price?

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P11.20 A 20-year, zero-coupon bond was recently quoted at 10.25% of par. Find the current yield and the
promised yield of this issue, given that the bond has a par value of $1,000. Using semiannual compounding,
determine how much an investor would have to pay for this bond if it were priced to yield 10%.

P11.21 Assume that an investor pays $800 for a long-term bond that carries an 8% coupon. In three years, he
hopes to sell the issue for $950. If his expectations come true, what yield will this investor realize? (Use annual
compounding.) What would the holding period return be if he were able to sell the bond (at $950) after only
nine months?

a)

N=3

PV = $800

FV = $950

PMT = $80 ( coupon payment @ 8% on FV of $1000)

I/Y = 15.38%

b)

Holding period return, HPR = (P1 - P0)/P0

Holding period return, HPR = (950-800)/800

HPR = 18.75%
1/0.75
HPR annualized = (1+ 18.75%)^ -1

HPR annualized = 25.75%

I have calculated both HPR for 9 months and annualized. Please post in the comment section, if you have any
questions. Thank you
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P11.22 Using annual compounding, find the yield to maturity for each of the following bonds.

a. A 9.5%, 20-year bond priced at $957.43

b. A 16%, 15-year bond priced at $1,684.76

c. A 5.5%, 18-year bond priced at $510.65

Now assume that each of the above bonds is callable as follows: Bond a is callable in seven years at a call
price of $1,095; bond b is callable in five years at $1,250; and bond c is callable in three years at $1,050. Use
annual compounding to find the yield to call for each bond.

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Yield to Maturity YTM

P11.23 A bond has a Macaulay duration equal to 8.3 and a yield to maturity of 6.2%. What is the modified
duration of this bond?

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P11.24 A bond has a Macaulay duration of 8.42 and is priced to yield 7%. If interest rates go up so that the
yield goes to 7.5%, what will be the percentage change in the price of the bond? Now, if the yield on this bond
goes down to 6.5%, what will be the bond’s percentage change in price? Comment on your findings.

Modified Duration = Macaulay Duration / (1 + YTM)

= 8.42/1.07 = 7.87

% change in bond price = -1 x Modified Duration x Change in Interest Rates

a) YTM = 7.5%

% change in bond price = -1 x 7.87 x 0.5% = -3.93%

% change in bond price = -1 x 7.87 x -0.5% = 3.93%

P11.25 An investor wants to find the duration of a 25-year, 6% semiannual-pay, noncallable bond that’s
currently priced in the market at $882.72, to yield 7%. Using a 50 basis point change in yield, find the effective
duration of this bond. (Hint: Use Equation 11.11.)

Effective Duration = (P(-) - P(+)) / (2 x P x i)

where P(-) - Price when rate declines by i, P(+) - Price when rate increases by i, P - Current Price = 882.72, i -
change in yield = 0.5%

P(-) can be calculated using PV function on a calculator

N = 25 x 2 = 50, PMT = 6% x 1000 / 2 = 30, FV = 1000, I/Y = 6.5%/2 = 3.25% => Compute PV = $938.62

Similarly, for P(+)

N = 50, PMT = 30, FV = 1000, I/Y = 7.5%/2 = 3.75% => Compute PV = $831.74

=> Effective Duration = (938.62 - 831.74) / (2 x 882.72 x 0.5%) = 12.11

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P11.26 Find the Macaulay duration and the modified duration of a 20-year, 10% corporate bond priced to yield
8%. According to the modified duration of this bond, how much of a price change would this bond incur if
market yields rose to 9%? Using annual compounding, calculate the price of this bond in one year if rates do
rise to 9%. How does this price change compare to that predicted by the modified duration? Explain the
difference.

P11.27 Which one of the following bonds would you select if you thought market interest rates were going to
fall by 50 basis points over the next six months?

a. A bond with a Macaulay duration of 8.46 years that’s currently being priced to yield 7.5%

b. A bond with a Macaulay duration of 9.30 years that’s priced to yield 10%

c. A bond with a Macaulay duration of 8.75 years that’s priced to yield 5.75%

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P11.28 Stacy Picone is an aggressive bond trader who likes to speculate on interest rate swings. Market
interest rates are currently at 9%, but she expects them to fall to 7% within a year. As a result, Stacy is thinking
about buying either a 25-year, zero-coupon bond or a 20-year, 7.5% bond. (Both bonds have $1,000 par
values and carry the same agency rating). Assuming that Stacy wants to maximize capital gains, which of the
two issues should she select? What if she wants to maximize the total return (interest income and capital
gains) from her investment? Why did one issue provide better capital gains than the other? Based on the
duration of each bond, which one should be more price volatile?

1. Duration increases with maturity and also increases with a decrease in coupon rate. Hence, zero coupon bond
has a higher duration. If rates are expected to decline, prices of bonds increase. Price of bond with higher duration
increases more. Hence, the price of zero coupon bond will rise more. Hence, invest in a zero coupon bond.

2. Total return will be highest for zero coupon bond

3.Zero coupon bond

P11.29 Elliot Karlin is a 35-year-old bank executive who has just inherited a large sum of money. Having spent
several years in the bank’s investments department, he’s well aware of the concept of duration and decides to
apply it to his bond portfolio. In particular, Elliot intends to use $1 million of his inheritance to purchase four
U.S. Treasury bonds:

a. An 8.5%, 13-year bond that’s priced at $1,045 to yield 7.47%

b. A 7.875%, 15-year bond that’s priced at $1,020 to yield 7.60%

c. A 20-year stripped Treasury that’s priced at $202 to yield 8.22%

d. A 24-year, 7.5% bond that’s priced at $955 to yield 7.90%

1. Find the duration and the modified duration of each bond.

2. Find the duration of the whole bond portfolio if Elliot puts $250,000 into each of

the four U.S. Treasury bonds.

3. Find the duration of the portfolio if Elliot puts $360,000 each into bonds a and c

and $140,000 each into bonds b and d.

4. Which portfolio—b or c—should Elliot select if he thinks rates are about to head up

and he wants to avoid as much price volatility as possible? Explain. From which

portfolio does he stand to make more in annual interest income? Which portfolio

would you recommend, and why?

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