Question

Airnova Inc. has two types of bonds, Bond D and Bond F. Both have 8 percent coupons, make semiannual payments, and are priced at par value. Bond D has 2 years to maturity. Bond F has 15 years to maturity.

Airnova Inc. is considering four different types of stocks. They each have a required return of 20 percent and a dividend of $3.75 for share. Stocks, A, B, and C are expected to maintain constant growth rates in dividends for the near future of 10 percent, 0 percent, and -5 percent, respectively. Stock D is a growth stock and will increase its dividend by 30 percent for the next four years and then maintain a constant 12 percent growth rate after that.

Discuss:

If interest rates suddenly rise by 2 percent, what is the percentage change in both bonds?

If interest rates suddenly fall by 2 percent, what is the percentage change in both bonds?

What does this tell you about the interest rate risk of longer-term bonds?

What is the dividend yield for each of the four stocks?

What is the expected capital gains yield?

Discuss the relationship among the various returns that you find for each of the stocks.

Answer 1

Since both the bonds are sold at par, the yield to maturity is 8%

now if rates rise by 2%, yield to maturity = 10%

Bond D: FV = 1000, PMT = 8%/2 of 1000 = 40, rate = 10%/2, N = 4

use PV function in Excel

price of Bond D = 964.54

% change in price = 964.54/1000 - 1 = -3.55%

Bond D: FV = 1000, PMT = 8%/2 of 1000 = 40, rate = 10%/2, N = 30

use PV function in Excel

price of Bond F = 846.2755

% change in price = 846.2755/1000 - 1 = -15.37%

now if rates drop by 2%, yield to maturity = 6%

Bond D: FV = 1000, PMT = 8%/2 of 1000 = 40, rate = 6%/2, N = 4

use PV function in Excel

price of Bond D = 1037.1710

% change in price = 1037.1710/1000 - 1 = 3.72%

Bond D: FV = 1000, PMT = 6%/2 of 1000 = 40, rate = 10%/2, N = 30

use PV function in Excel

price of Bond F = 846.2755

% change in price = 1196.0044/1000 - 1 = 19.60%

c. Longer the tenure of the bonds higher is the sensitivity to interest rate risk

d. dividend yield of A = 20% - 10% = 10%

dividend yield of B = 20% - 0% = 20%

dividend yield of A = 20% - -5% = 25%

dividend yield of A = 20% - 30% = -10%

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