Question

•Note the following yields: 10 year treasury 2.37%, 10 year AAA rated bond credit spread 0.90% (90 basis points), BBB rated bond credit spread 1.20% (120 basis points). What is the price of a 10 year bond, $1000 par value, with a coupon rate of 6% that pays interest semi-annually and has risk similar to a BBB rated corporate bond?

•Suppose Company X has earnings next year of $1.00 and grows earnings by 40% for 2 years and will grow earnings thereafter by 4%. It pays no dividends until year 4, where it will then initiate a 50% dividend payout rate. If the cost of equity capital is 12%, what is the price of the stock?

Answer 1

1). YTM = 10 yr Treasury + Credit Spread = 2.37% + 1.20% = 3.57%

To find the bond price, we need to put the following values in the financial calculator:

INPUT	10x2=20	3.57/2=1.785		(6%/2)x1,000=30	1,000
TVM	N	I/Y	PV	PMT	FV
OUTPUT			-1,202.85

So, Bond Price = $1,202.85

2). D5 = E5 x DPR = $1 x 0.50 = $0.50

P0 = D5 / (1 + r)⁵ + D5 / (1 + r)⁶ + D5(1 + g1)² / (1 + r)⁷ + [D5(1 + g1)²(1 + g_c)] / [(r - g_c)(1 + r)⁷]

= $0.50 / 1.12⁵ + [$0.50(1.40) / (1.12⁶)] + [$0.50(1.40)² / (1.12⁷)] +

[$0.50(1.40)²(1.04)] / (0.12 - 0.04)(1.12⁷)]

= $0.28 + $0.35 + $0.44 + $5.76 = $6.84