Bonds, Preferred Stock, and Common Stock

Transcription

1 Bonds, Preferred Stock, and Common Stock 1. Preferred stock promises to pay a dividend of $50 per year. The stock is currently selling at a price of $200. What is the rate of return on the stock? 2. An investor has a required rate of return of 10% on a 5-year discount bond ($100 face value). What is the most the investor would pay for this bond? 3. A U.S. Treasury bond has an interest rate of 1.5%. The stock market as a whole is expected to have a rate of return of 7%. A particular stock has a beta of 2. According to CAPM, what is the required return on the stock? 4. An investor has a required rate of return of 30% for a common stock. The stock is expected to pay a divided of $5 next year and grow at a rate of 10% per year. According to the Gordon Model, what is the most the investor would pay for this stock? 5. A common stock is expected to pay a dividend of $15 next year and grow at a rate of 4% per year. The stock is currently selling at a price of $60. According to the Gordon Model, what is the expected rate of return on this stock? 6. A consol is a type of bond that pays a regular coupon payment forever. This consol is paying an annual $50 coupon bond. An investor requires an interest rate of 8% to purchase this bond. How much would the investor be willing to pay for this bond?

2 7. A preferred stock is paying a $30 dividend per year. The stock is currently selling for $150. What is the rate of return on this stock? 8. An investor has a required rate of return of 20% on a 2-year, 10% coupon bond ($100 face value, the 10% is the coupon rate). What is the most that the investor would be willing to pay for this bond? 9. A U.S. Treasury bond has an interest rate of 4%. The stock market as a whole is expected to have a rate of return of 10%. A particular stock has a beta of 0.5. According to CAPM, what is the required return on the stock? 10. A U.S. Treasury bond has an interest rate of 4%. The stock market as a whole is expected to have a rate of return of 10%. A particular stock has a beta of 1.5. According to CAPM, what is the required return on the stock? 11. A consol (i.e., the bond that makes annual payments forever) currently sells for $800. The consol makes annual payments of $40. What is the current yield to maturity on the consol? 12. A preferred stock currently sells for $100 and makes annual dividend payments of $15. What is the dividend yield on the stock (i.e., what is the required return on the stock)?

3 Weighted Average Cost of Capital (WACC) 13. A corporation s market value of debt of $20 million and market value of equity of $80 million. The cost of debt for the corporation is 10%. The cost of equity is 20%. Ignoring taxes, calculate the WACC for the corporation. 14. A corporation s market value of debt of $80 million and market value of equity of $20 million. The cost of debt for the corporation is 10%. The cost of equity is 20%. Ignoring taxes, calculate the WACC for the corporation. 15. A corporation s market value of debt of $80 million and market value of equity of $20 million. The cost of debt for the corporation is 10%. The cost of equity is 20%. Assuming the tax rate is 50%, calculate the WACC for the corporation. 16. A corporation has three sources of capital: bonds, preferred stock, common stock. The market value of the bonds is $50 million and carries a cost of debt of 6%. The market value of the preferred stock is $25 million and carries a cost of 8%. The market value of common stock is $25 million and carries a cost of 16%. Ignoring taxes, calculate the WACC for the corporation. 17. A corporation has two sources of capital: consols (i.e., the bonds that make payments forever) and common stock. The consols have a market value of $40 million and make annual payments totaling $4 million per year. The common stock has a market value of $60 million. The stock s beta is 2, risk-free rate is 7% and expected market return 11%. Ignoring taxes, calculate the WACC for the corporation.

4 Net Present Value (NPV) and Internal Rate of Return (IRR) 18. Leo s Law Service is considering purchasing a new riding lawn mower. The mower has a cost of $4,000 and should last for two years. Leo has estimated that the mower will generate net income of $3,000 in the first year and $2,000 in the second year. Leo utilizes a 5% cost of capital. If Leo uses the Net Present Value method, should he purchase the mower? 19. Suppose Leo actually had a 20% required rate of return. If this were the case, then should he do the investment? 20. Endrun Corporation is considering a rather larger investment opportunity. The project cost comes to an initial outlay of $150 million with an expected additional net income of $40 million each year for the next 100 years. Assume we can approximate our calculations rather well by assuming 100 years is nearly forever for our purposes. If Endrun has a cost of capital of 25% on investment projects, then according to the net present value method should they do it? 21. What is the internal rate of return for the project in question 20 (again, assume we can approximate things by assuming the thing lasts forever)? 22. Endrun Corporation is considering an investment project with an initial outlay of $1 million. The project is expected to generate net income of $1.2 million at the end of the first year and nothing afterwards. What is the internal rate of return for this project? 23. If Endrun uses a 5% cost of capital, then what is the NPV for the project in question 22?

5 More-or-Less Complete Example 24. U-Poor Coffee Corporation is considering investing in a new state-of-the-art warehouse facility. The cost of the facility is $500,000. The investment is expected to generate additional cash flows of $60,000 per year over the next 50 years (thus, for certain calculations we ll assume the project generates these additional cash flows essentially forever again, this just makes some calculations easier to do by hand or calculator). U-Poor currently has its optimal composition of capital in the following form (dollar amounts are in millions). Type of Security Value of Securities % of Total Current Return Bonds $40 Preferred Stock $10 Common Stock $50 The bonds are consols currently selling for $60 with annual payments of $4.80. The preferred stock pays a dividend of $10 per year and currently sells for $100. The common stock has a beta of 0.5, risk-free rate is 5% and expected market return is 19%. a. Complete the above table. b. Calculate U-Poor s Weighted Average Cost of Capital (WACC). Ignoring taxes.

6 c. If U-Poor uses the Net Present Value (NPV) method for determining investment projects, should they invest in the warehouse? d. If U-Poor uses the Internal Rate of Return (IRR) method for determining investment projects, should they invest in the warehouse?