CHAPTER 5

HOW TO VALUE STOCKS AND 
BONDS

Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require
multiple steps. Due to space and readability constraints, when these intermediate steps are
included in this solutions manual, rounding may appear to have occurred. However, the final
answer for each problem is found without rounding during any step in the problem.

NOTE: Most problems do not explicitly list a par value for bonds. Even though a bond can have
any par value, in general, corporate bonds in the United States will have a par value of $1,000.
We will use this par value in all problems unless a different par value is explicitly stated.

1. The price of a pure discount (zero coupon) bond is the present value of the par. Even though
the bond makes no coupon payments, the present value is found using semiannual
compounding periods, consistent with coupon bonds. This is a bond pricing convention. So,
the price of the bond for each YTM is:

a. P = $1,000/(1 + .025)20 = $610.27

b. P = $1,000/(1 + .05)20 = $376.89

c. P = $1,000/(1 + .075)20 = $235.41

3. Here we are finding the YTM of a semiannual coupon bond. The bond price equation is:

P = $970 = $43(PVIFAR%,20) + $1,000(PVIFR%,20)

Since we cannot solve the equation directly for R, using a spreadsheet, a financial calculator,
or trial and error, we find:

R = 4.531%

Since the coupon payments are semiannual, this is the semiannual interest rate. The YTM is
the APR of the bond, so:

YTM = 2  4.531% = 9.06%

5. We need to find the required return of the stock. Using the constant growth model, we can
solve the equation for R. Doing so, we find:
 R = (D1 / P0) + g = ($3.10 / $48.00) + .05 = 11.46%

7. We know the stock has a required return of 12 percent, and the dividend and capital gains
yield are equal, so:

Dividend yield = 1/2(.12) = .06 = Capital gains yield

Now we know both the dividend yield and capital gains yield. The dividend is simply the
stock price times the dividend yield, so:

D1 = .06($70) = $4.20

This is the dividend next year. The question asks for the dividend this year. Using the
relationship between the dividend this year and the dividend next year:

D1 = D0(1 + g)

We can solve for the dividend that was just paid:

$4.20 = D0 (1 + .06)

D0 = $4.20 / 1.06 = $3.96

9. The growth rate of earnings is the return on equity times the retention ratio, so:

g = ROE × b
g = .14(.60)
g = .084 or 8.40%

To find next year’s earnings, we simply multiply the current earnings times one plus the
growth rate, so:

Next year’s earnings = Current earnings(1 + g)

11. The bond price equation for this bond is:

P0 = $1,040 = $42(PVIFAR%,18) + $1,000(PVIFR%,18)

Using a spreadsheet, financial calculator, or trial and error we find:

R = 3.887%

This is the semiannual interest rate, so the YTM is:

YTM = 2  3.887% = 7.77%

The current yield is:

The effective annual yield is the same as the EAR, so using the EAR equation from the
previous chapter:

Effective annual yield = (1 + 0.03887)2 – 1 = 7.92%

12. The company should set the coupon rate on its new bonds equal to the required return. The
required return can be observed in the market by finding the YTM on outstanding bonds of
the company. So, the YTM on the bonds currently sold in the market is:

P = $1,095 = $40(PVIFAR%,40) + $1,000(PVIFR%,40)

Using a spreadsheet, financial calculator, or trial and error we find:

R = 3.55%

This is the semiannual interest rate, so the YTM is:

YTM = 2  3.55% = 7.10%

13. This stock has a constant growth rate of dividends, but the required return changes twice. To
find the value of the stock today, we will begin by finding the price of the stock at Year 6,
when both the dividend growth rate and the required return are stable forever. The price of
the stock in Year 6 will be the dividend in Year 7, divided by the required return minus the
growth rate in dividends. So:

P6 = D6 (1 + g) / (R – g) = D0 (1 + g)7 / (R – g) = $3.00 (1.05)7 / (.11 – .05) = $70.36

Now we can find the price of the stock in Year 3. We need to find the price here since the
required return changes at that time. The price of the stock in Year 3 is the PV of the
dividends in Years 4, 5, and 6, plus the PV of the stock price in Year 6. The price of the stock
in Year 3 is:

P3 = $3.00(1.05)4 / 1.14 + $3.00(1.05)5 / 1.142 + $3.00(1.05)6 / 1.143 + $70.36 / 1.143

Finally, we can find the price of the stock today. The price today will be the PV of the
dividends in Years 1, 2, and 3, plus the PV of the stock in Year 3. The price of the stock
today is:

P0 = $3.00(1.05) / 1.16 + $3.00(1.05)2 / (1.16)2 + $3.00(1.05)3 / (1.16)3 + $56.35 / (1.16)3

16. With supernormal dividends, we find the price of the stock when the dividends level off at a
constant growth rate, and then find the PV of the future stock price, plus the PV of all
dividends during the supernormal growth period. The stock begins constant growth in Year
5, so we can find the price of the stock in Year 4, one year before the constant dividend
growth begins, as:
 P4 = D4 (1 + g) / (R – g) = $2.00(1.05) / (.13 – .05) = $26.25

The price of the stock today is the PV of the first four dividends, plus the PV of the Year 4
stock price. So, the price of the stock today will be:

P0 = $8.00 / 1.13 + $6.00 / 1.132 + $3.00 / 1.133 + $2.00 / 1.134 + $26.25 / 1.134 = $31.18

17. With supernormal dividends, we find the price of the stock when the dividends level off at a
constant growth rate, and then find the PV of the future stock price, plus the PV of all
dividends during the supernormal growth period. The stock begins constant growth in Year
4, so we can find the price of the stock in Year 3, one year before the constant dividend
growth begins as:

P3 = D3 (1 + g) / (R – g) = D0 (1 + g1)3 (1 + g2) / (R – g2) = $2.80(1.25)3(1.07) / (.13 – .07) =

The price of the stock today is the PV of the first three dividends, plus the PV of the Year 3
stock price. The price of the stock today will be:

P0 = 2.80(1.25) / 1.13 + $2.80(1.25)2 / 1.132 + $2.80(1.25)3 / 1.133 + $97.53 / 1.133