FINC311 – Investments

Chapter 2
Tutorial – 1 March

Lecturer: Huong Dang huong.dang@canterbury.ac.nz

Tutor: Zach Logan zal28@uclive.ac.nz

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 Notes
• Tutor: Zach Logan. Email: zal28@uclive.ac.nz
• If you attend a tutorial, please make sure you have access to the problem
sets posted in the tutorial folder on Learn prior to each tutorial
• Due to copyright related issues, the lecturer cannot post on Learn all
materials
• Tutorial questions may include end-of-chapter problem sets, past term test
and past exam questions, additional case study (which will be posted on
Learn prior to each tutorial)
• You should attempt to do all assigned questions, some may not be covered
in the tutorial due to time constraints
• Solutions to tutorial questions will be posted on Learn by Monday
morning of the following week (during term time).
• You should subscribe to the class forum on Learn

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 Problem 1
1. In what ways is preferred stock like long term
debt? In what way it is like equity?
Preferred stock is like long-term debt in that it typically promises a fixed payment
each year. In this way, it is a perpetuity. Preferred stock is also like long-term debt in
that it does not give the holder voting rights in the firm.
Preferred stock is like equity in that the firm is under no contractual obligation to
make the preferred stock dividend payments. Failure to make payments does not set
off corporate bankruptcy. With respect to the priority of claims to the assets of the
firm in the event of corporate bankruptcy, preferred stock has a higher priority than
common equity but a lower priority than bonds.

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 Problem 2
2. Why are money market securities sometimes
referred to as “cash equivalents”?
Money market securities are called cash equivalents because of their high level
of liquidity. The prices of money market securities are very stable, and they can
be converted to cash (i.e., sold) on very short notice and with very low
transaction costs. Examples of money market securities include Treasury bills,
commercial paper, and banker's acceptances, each of which is highly marketable
and traded in the secondary market.

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 Problem 5
5. What are the key differences between common
stock, preferred stock, and corporate bonds?
Corp. Bonds Preferred Stock Common Stock

Voting rights (typically) Yes

Contractual obligation Yes

Perpetual payments Yes Yes

Accumulated dividends Yes

Fixed payments (typically) Yes Yes

Payment preference First Second Third

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 Problem 6
6. Why are high-tax-bracket investors more
inclined to invest in municipal bonds than low
bracket investors?
Municipal bond interest is tax-exempt at the federal level and possibly at the state
level as well. When facing higher marginal tax rates, a high-income investor
would be more inclined to invest in tax-exempt securities.

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 Problem 7
7. Turn back to Figure 2.3 and look at the Treasury bond
maturing in August 2048.
• How much would you have to pay to purchase one of
these bonds?
You would have to pay the ask price of 101.9297% of par value of $1,000 =
$1,019.297

• What is its coupon rate?

The coupon rate is 3.000%; implying coupon payments of $30.00 annually or,
more precisely $15.00 (semiannually).

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 Problem 7
7. Turn back to Figure 2.3 and look at the Treasury bond
maturing in August 2048.
• What is the yield to maturity of the bond?
The yield to maturity on a fixed income security is also known as its required return
and is reported by The Wall Street Journal and others in the financial press as the
ask yield. In this case, the yield to maturity is 2.902%. An investor buying this
security today and holding it until it matures will earn an annual return of 2.902%.

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Problem 7

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 Problem 8
8. Suppose investors can earn a return of 2% per 6
months on a Treasury note with 6 months remaining
until maturity. What price would you expect a 6-month
maturity Treasury bill to sell for?
Treasury bills are discount securities that mature for $10,000. Therefore, a specific T-
bill price is simply the maturity value divided by one plus the semi-annual return:

P = $10,000/1.02 = $9,803.92

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 Problem 10
10. Turn to Figure 2.8 and look at the listing for
Herbalife.
•How many shares could you buy for $5000?
You could buy: $5,000/$57.94 = 86.30 shares.
Since it is not possible to trade in fractions of shares, you could buy 86 shares of
Herbalife

•What would be your annual dividend income from

those shares?
Your annual dividend income would be: 86  $1.20 = $103.20

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 Problem 10
10. Turn to Figure 2.8 and look at the listing for
Herbalife.
•What must be Herbalifes’s earnings per share?
The price-to-earnings ratio is 47.75 and the price is $57.94. Therefore:
$57.94/Earnings per share = 47.75
 Earnings per share = $1.21

(Note: we will learn about P/E at the end of the term 2. This will not be tested in the
test)

•What was the firm’s closing price on the day before

the listing?
Herbalife closed today at $57.94, which was $1.39 lower than yesterday’s price of
$59.33.

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Problem 10

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 Problem 11
Problem 11.
Consider the three stocks in the following table. Pt represents
price at time t, and Qt represents share outstanding at time t.
Stock C splits two for one in the last period.
a. Calculate the rate of return on a price-weighted index of the
three stocks for the first period (t=0 to t=1).
b. What must happen to the divisor for the price- weighted
index in year 2?
c. Calculate the rate of return for the second period (t=1 to
t=2).
P0 Q0 P1 Q1 P2 Q2

A
90 100 95 100 95 100
B
50 200 45 200 45 200
C
100 200 110 200 55 400
 Problem 11
a. At t = 0, the value of the index is: (90 + 50 + 100)/3 = 80
At t = 1, the value of the index is: (95 + 45 + 110)/3 = 83.333
The rate of return is: (83.333/80) - 1 = 4.17%

b. In the absence of a split, Stock C would sell for 110, so the

value of the index would be: (95+45+110)/3 = 250/3 = 83.333 with
a divisor of 3.
After the split, stock C sells for 55. Therefore, we need to find the
divisor (d) such that: 83.333 = (95 + 45 + 55)/d
-> d = 2.340.
The divisor fell, which is always the case after one of the firms in
an index splits its shares.

c. The return is zero. The index remains unchanged because the

return for each stock separately equals zero.
 Problem 12
Problem 12.
Using the data in the previous problem, calculate the first-period rates of return on
the following indexes of the three stocks:
a. A market-value-weighted index.
b. An equally weighted index.
 Problem 12
a. Total market value at t = 0 is:
($9,000 + $10,000 + $20,000) = $39,000
Total market value at t = 1 is:
($9,500 + $9,000 + $22,000) = $40,500
Rate of return = ($40,500/$39,000) – 1 = 3.85%

b. The return on each stock is as follows:

rA = (95/90) – 1 = 0.0556
rB = (45/50) – 1 = –0.10
rC = (110/100) – 1 = 0.10
The equally weighted average is:
[0.0556 + (-0.10) + 0.10]/3 = 0.0185 = 1.85%
 Problem 13
13. An investor is in a 30% tax bracket. If
corporate bonds offer 6% yield, what must
municipals offer for the investor to prefer
them to corporate bonds?
The after-tax yield on the corporate bonds is: 0.06  (1 – 0.30) = 0.042 = 4.2%
Therefore, municipals must offer a yield to maturity of at least 4.2%.

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 Problem 14
14. Find the equivalent taxable yield of a short
term municipal bond currently offering yields
of 4% for tax brackets of zero, 10%, 20% and
30%
the equivalent taxable yield is: r = rm /(1 – t), so simply substitute each tax rate in the
denominator to obtain the following:
a. 4/(1 – 0) = 4.00%
b. 4/(1 – 0.1) = 4.44%
c. 4/(1 – 0.2) = 5.00%
d. 4/(1 – 0.3) = 5.71%

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 Problem 15
What problems would confront a mutual fund trying to create an
index fund tied to an equally weighted index of a broad stock
market?

Answer: A mutual fund typically follows a low-cost investment

strategy (i.e. buy and hold). An equally weighted index is not
suitable to a buy and hold strategy, which would require regular
rebalancing (i.e. sell securities whose price increase and buy
securities whose price decrease as time passes). Transaction costs
in New Zealand are very high, which make this equally-weighted
index investment strategy expensive.

Please refer to the detailed answer at the end of the recorded

lecture (week 1). Thanks.