1. After graduation, Adrian moved across the country to Brownville and bought a small house for $208,000.

Bill moved to Columbus and bought a house for $195,000. Four years later, they both sold their houses. Adrian netted $256,000 when she sold her house and Bill netted $168,000 on his. a. What annual rate of return did Adrian realize on her house? b. What annual rate of return did Bill realize on his house? a. CALC: b. CALC: a. PV = C 1 (1 + r ) 4 1 (1 + r ) 4 n = 4 r = ? PV = -$208,000 PMT = 0 FV = $256,000 r = 5.33% n = 4 r = ? PV = -$195,000 PMT = 0 FV = $168,000 r = -3.66%

$208, 000 = $256, 000 $208, 000 1 = $256, 000 (1 + r ) 4 1 (1 + r ) 4 1 (1 + r ) 4 = 0.8125 4 (1 + r ) = 1.23077 0.8125 =
4

(1 + r ) 4 = 4 1.23077

(1 + r ) = 1.05328 r = 1.05328 1 r = 0.05328 r = 5.33% b. PV = C 1 (1 + r ) 4 1 (1 + r ) 4

$195, 000 = $168, 000

$195, 000 1 = $168, 000 (1 + r ) 4 1 1.16071 = (1 + r ) 4 1 (1 + r ) 4 = 1.16071 4 (1 + r ) = 0.861538

4

(1 + r ) 4 = 4 0.861538

(1 + r ) = 0.963427 r = 0.963427 1 r = 0.036573 r = -3.66% 2. Assume an ordinary annuity of $500 at the end of each of the next three years. a. What is the present value discounted at 10%? b. What is the future value at the end of year 3 if cash flows can be invested at 10%? a. CALC: n = 3 r = ? PV = ? r = 10% PMT = $500.00 FV = 0 PV = -$1,243.43 b. CALC: n = 3 r = ? PV = 0 r = 10% PMT = $500.00 FV = ? FV = -$1,655.00 a. PV = 1 $500 1 (1.10)3 0.10

= $1,243.43 b. FV= $500 = $1,655 A1.(Bond valuation) A $1,000 face value bond has a remaining maturity of 10 years and a required return of 9%. The bonds coupon rate is 7.4%. What is the fair value of this bond? [(1.1)3 1] 0.1

CALC: n = 10 x 2 r = 9% / 2 PV = ? PMT = 7.4% x 1,000 / 2 = 37 FV = 1,000 PV = -$895.94 A10. .(Dividend discount model) Assume RHM is expected to pay a total cash dividend of $5.60 next year and its dividends are expected to grow at a rate of 6% per year forever. Assuming annual dividend payments, what is the current market value of a share of RHM stock if the required return on RHM common stock is 10%? P0 = D1 / (r - g) = $5.60 / (0.10 - 0.06) = $140.00 A12.(Required return for a preferred stock) James River $3.38 preferred is selling for $45.25. The preferred dividend is nongrowing. What is the required return on James River preferred stock? PVPerpetuity = D / r = D / PV = $3.38 / $45.25 = 7.47% A14. (Stock valuation) Suppose Toyota has nonmaturing (perpetual) preferred stock outstanding that pays a $1.00 quarterly dividend and has a required return of 12% APR (3% per quarter). What is the stock worth? PVPerpetuity = D / r = $1.00 / 0.03 = $33.33 (Interest-rate risk) Philadelphia Electric has many bonds trading on the New York Stock Exchange. Suppose PhilEls bonds have identical coupon rates of 9.125% but that one issue matures in 1 year, one in 7 years, and the third in 15 years. Assume that a coupon payment was made yesterday. a. If the yield to maturity for all three bonds is 8%, what is the fair price of each bond? b. Suppose that the yield to maturity for all of these bonds changed instantaneously to 7%. What is the fair price of each bond now? c. Suppose that the yield to maturity for all of these bonds changed instantaneously again, this time to 9%. Now what is the fair price of each bond? d. Based on the fair prices at the various yields to maturity, is interest-rate risk the same, higher, or lower for longer- versus shorter-maturity bonds? a. 1. CALC: n = 1 x 2 = 2 r = 8% / 2 = 4% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,010.61 2. CALC: n = 7 x 2 = 14 r = 8% / 2 = 4% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,059.42

3. CALC: n = 15 x 2 = 30 r = 8% / 2 = 4% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,097.27 b. 1. CALC: n = 1 x 2 = 2 r = 7% / 2 = 3.5% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,020.18 2. CALC: n = 7 x 2 = 14 r = 7% / 2 = 3.5% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,116.03 3. CALC: n = 15 x 2 = 30 r = 7% / 2 = 3.5% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,195.42 c. 1. CALC: n = 1 x 2 = 2 r = 9% / 2 = 4.5% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,001.17 2. CALC: n = 7 x 2 = 14 r = 9% / 2 = 4.5% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,006.39 3. CALC: n = 15 x 2 = 30 r = 9% / 2 = 4.5% PV = ? PMT = 9.125% x 1,000 / 2 = $45.625 FV = $1,000 PV = -$1,010.18 d. Interest-rate risk varies directly with maturity. The longer maturity of the bonds, the larger the price change is when interest rates change. B18. (Default risk) You buy a very risky bond that promises a 9.5% coupon and return of the $1,000 principal in 10 years. You pay only $500 for the bond. a. You receive the coupon payments for three years and the bond defaults. After liquidating the firm, the bondholders receive a distribution of $150 per bond at the end of 3.5 years. What is the realized return on your investment? b. The firm does far better than expected and bondholders receive all of the promised interest and principal payments. What is the realized return on your investment? a. CALC: n = 3.5x2 =7 r = ? PV = -$500 PMT = 9.5%x1,000/ 2= $47.50 FV = $150 - 47.50 = $102.50 r = -2.8746% APY = (1 + r)m 1 = (1 - 0.0278)2 1 = -5.6666% YTM = 2x(-2.8746) = -5.7493% APR b. CALC: n = 10x2 =20 r = ? PV = -$500 PMT = 9.5%x1,000/2 = $47.50 FV = $1,000 r = 11.0489% APY = (1 + r)m 1 = (1 + 0.110489)2 1 = 23.3185%

YTM = 2x11.0489 = 22.0977% APR B20. (Constant growth model) Medtrans is a profitable firm that is not paying a dividend on its common stock. James Weber, an analyst for A. G. Edwards, believes that Medtrans will begin paying a $1.00 per share dividend in two years and that the dividend will increase 6% annually thereafter. Bret Kimes, one of James colleagues at the same firm, is less optimistic. Bret thinks that Medtrans will begin paying a dividend in four years, that the dividend will be $1.00, and that it will grow at 4% annually. James and Bret agree that the required return for Medtrans is 13%. a. What value would James estimate for this firm? b. What value would Bret assign to the Medtrans stock? a. P1 = D2 / (r - g) = $1.00 / (0.13 - 0.06) = $14.29 P0 = $14.29 / (1 + 0.13)1 = $12.64 b. P3 = D4 / (r - g) = $1.00 / (0.13 - 0.04) = $11.11 P0 = $11.11 / (1 + 0.13)3 = $7.70 C1. (Beta and required return) The riskless return is currently 6%, and Chicago Gear has estimated the contingent returns given here. a. Calculate the expected returns on the stock market and on Chicago Gear stock. b. What is Chicago Gears beta? c. What is Chicago Gears required return according to the CAPM? REALIZED RETURN State of the Market Gear Stagnant Slow growth Average growth Rapid growth Probability that State Occurs 0.20 0.35 0.30 0.15 Stock Market Chicago (10%) 10 15 25 (15%) 15 25 35

a. Expected Return M = 0.20 x -.10% + 0.35 x 10% + 0.30 x 15% + 0.15 x 25% = 9.75% Expected Return Chicago Gear = 0.20 x -.15% + 0.35 x 15% + 0.30 x 25% + 0.15 x 35% = 15.00% b. M2 = 0.20(-0.10 - 0.0975)2 + 0.35(0.10 - 0.0975)2 + 0.30(0.15 - 0.0975)2 + 0.15(0.25 - 0.0975)2 = 0.0121 Cov(Chicago Gear, M) = 0.20(-0.15 - 0.15)(-0.10 - 0.0975) + 0.35(0.15 - 0.15)(0.10 - 0.0975) + 0.30(0.25 - 0.15)(0.15 - 0.0975) + 0.15(0.35 - 0.15)(0.25 - 0.0975) = 0.018 = Cov(j,M) / M2 = 0.018 / 0.0121 = 1.49 c.r = rf + (rM - rf) = 0.06 + 1.49(0.0975 - 0.06) = 0.1159 = 11.59%