Chapter 03

Interest Rates and Security Valuation

 

True / False Questions

 

1. If interest rates increase, the value of a fixed income contract decreases and vice versa. 
 
True    False
 
2.
At equilibrium, a security's required rate of return will be less than its expected rate of return.

 
 
True    False
 
3. If a security's realized return is negative, it must have been true that the expected return was greater than
the required return. 
 
True    False
 
4. Suppose two bonds of equivalent risk and maturity have different prices such that one is a premium bond
and one is a discount bond. The premium bond must have a greater expected return than the discount bond. 
 
True    False
 
5.
A bond with an 11 percent coupon and a 9 percent required return will sell at a premium to par. 

 
 
True    False
 
6. A fairly priced bond with a coupon less than the expected return must sell at a discount from par. 
 
True    False
 
7. All else equal, the holder of a fairly priced premium bond must expect a capital loss over the holding
period. 
 
True    False
 

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8.
The duration of a four-year maturity 10 percent coupon bond is less than four years. 

 
 
True    False
 
9.
The longer the time to maturity, the lower the security's price sensitivity to an interest rate change, ceteris
paribus.

 
 
True    False
 
10. The greater a security's coupon, the lower the security's price sensitivity to an interest rate change, ceteris
paribus. 
 
True    False
 
11. For a given interest rate change, a 20-year bond's price change will be twice that of a 10-year bond's price
change. 
 
True    False
 
12. Any security that returns a greater percentage of the price sooner is less price-volatile. 
 
True    False
 
13. A zero coupon bond has a duration equal to its maturity and a convexity equal to zero. 
 
True    False
 
14. The lower the level of interest rates, the greater a bond's price sensitivity to interest rate changes. 
 
True    False
 
15. The higher a bond's coupon, the lower the bond's price volatility. 
 
True    False
 
16. Higher interest rates lead to lower bond convexity, ceteris paribus. 
 
True    False
 
17.
A 10-year maturity zero coupon bond will have lower price volatility than a 10-year bond with a 10 percent
coupon. 

 
 
True    False
 

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18. Ignoring default risk, if a bond's expected return is greater than its required return, then the bond's market
price must be greater than the present value of the bond's cash flows. 
 
True    False
 
 

Multiple Choice Questions

 

19. The required rate of return on a bond is 

 

A. the interest rate that equates the current market price of the bond with the present value of all future cash
flows received.
B. 
equivalent to the current yield for non-par bonds.

C. 
less than the E(r) for discount bonds and greater than the E(r) for premium bonds.

D. inversely related to a bond's risk and coupon.

E. 
none of the options.

 
20. Duration is 
 

A. the elasticity of a security's value to small coupon changes.

B. the weighted average time to maturity of the bond's cash flows.
C.  the time until the investor recovers the price of the bond in today's dollars.
D. greater than maturity for deep discount bonds and less than maturity for premium bonds.
E. 
the second derivative of the bond price formula with respect to the YTM.

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21.
Which of the following bond terms are generally positively related to bond price volatility?

I. Coupon rate
II. Maturity
III. YTM
IV. Payment frequency

 
 

A. II and IV only

B. I and III only
C.  II and III only
D. II
only
E.  II, III, and IV only
 
22. The interest rate used to find the present value of a financial security is the 
 

A. expected rate of return.

B. required rate of return.
C.  realized rate of return.
D. realized yield to maturity.
E.  current yield.
 
23. A security has an expected return less than its required return. This security is 
 

A. selling at a premium to par.

B. selling at a discount to par.
C.  selling for more than its PV.
D. selling for less than its PV.
E.  a zero coupon bond.
 

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24.
A bond that you held to maturity had a realized return of 8 percent, but when you bought it, it had an
expected return of 6 percent. If no default occurred, which one of the following must be true?

 
 

A. The bond was purchased at a premium to par.

B. 
The coupon rate was 8 percent.

C. 
The required return was greater than 6 percent.

D. The coupons were reinvested at a higher rate than expected.

E.  The bond must have been a zero coupon bond.
 
25.
You would want to purchase a security if P ____________ PV or E(r)  ____________ r.

 
 

A. ≥; ≤
B. ≥; ≥
C.  ≤; ≥
D. ≤; ≤
 
26. A 10-year annual payment corporate bond has a market price of $1,050. It pays annual interest of $100 and
its required rate of return is 9 percent. By how much is the bond mispriced?  
 

A. $0.00
B. Overpriced by $14.18
C.  Underpriced by $14.18
D. Overpriced by $9.32
E.  Underpriced by $9.32
 
27. A 12-year annual payment corporate bond has a market price of $925. It pays annual interest of $60 and its
required rate of return is 7 percent. By how much is the bond mispriced?  
 

A. $0.00
B. Overpriced by $7.29
C.  Underpriced by $7.29
D. Overpriced by $4.43
E.  Underpriced by $4.43
 

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28. An eight-year corporate bond has a 7 percent coupon rate. What should be the bond's price if the required
return is 6 percent and the bond pays interest semiannually?  
 

A. $1,062.81
B. $1,062.10
C.  $1,053.45
D. $1,052.99
E.  $1,049.49
 
29. A 15-year corporate bond pays $40 interest every six months. What is the bond's price if the bond's
promised YTM is 5.5 percent?  
 

A. $1,261.32
B. $1,253.12
C.  $1,250.94
D. $1,263.45
E.  $1,264.79
 
30. A corporate bond has a coupon rate of 10 percent and a required return of 10 percent. This bond's price is  
 

A. $924.18.
B. $1,000.00.
C.  $879.68.
D. $1,124.83.
E.  not possible to determine from the information given.
 
31.
A 10-year annual payment corporate coupon bond has an expected return of 11 percent and a required
return of 10 percent. The bond's market price is 

 
 

A. greater than its PV.

B. less than par.
C. 
less than its E(r).

D. less than its PV.

E. 
$1,000.00.

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32. An eight-year annual payment 7 percent coupon Treasury bond has a price of $1,075. The bond's annual
E(r) must be  
 

A. 13.49 percent.
B. 5.80 percent.
C.  7.00 percent.
D. 1.69 percent.
E.  4.25 percent.
 
33. A six-year annual payment corporate bond has a required return of 9.5 percent and an 8 percent coupon. Its
market value is $20 over its PV. What is the bond's E(r)?  
 

A. 8.00 percent
B. 10.21 percent
C.  9.98 percent
D. 9.03 percent
E.  3.53 percent
 
34. Corporate Bond A returns 5 percent of its cost in PV terms in each of the first five years and 75 percent of
its value in the sixth year. Corporate Bond B returns 8 percent of its cost in PV terms in each of the first
five years and 60 percent of its cost in the sixth year. If A and B have the same required return, which of
the following is/are true?

I. Bond A has a bigger coupon than Bond B.

II. Bond A has a longer duration than Bond B.
III. Bond A is less price-volatile than Bond B.
IV. Bond B has a higher FPV than Bond A.  
 

A. III
only
B. I, III, and IV only
C.  I, II, and IV only
D. II and IV only
E.  I, II, III, and
IV
 
35. A corporate bond returns 12 percent of its cost (in PV terms) in the first year, 11 percent in the second year,
10 percent in the third year and the remainder in the fourth year. What is the bond's duration in years?  
 

A. 3.68 years
B. 2.50 years
C.  4.00 years
D. 3.75 years
E.  3.32 years
 

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36. A semiannual payment bond with a $1,000 par has a 7 percent quoted coupon rate, a 7 percent promised
YTM, and 10 years to maturity. What is the bond's duration?  
 

A. 10.00 years
B. 8.39 years
C.  6.45 years
D. 5.20 years
E.  7.35 years
 
37. An annual payment bond with a $1,000 par has a 5 percent quoted coupon rate, a 6 percent promised YTM,
and six years to maturity. What is the bond's duration?  
 

A. 5.31 years
B. 5.25 years
C.  4.76 years
D. 4.16 years
E.  3.19 years
 
38. If an N year security recovered the same percentage of its cost in PV terms each year, the duration would
be  
 

A. N.
B. 0.
C.  sum of the years/N.
D. N!/N2.
E.  none of the options.
 
39. The ___________ the coupon and the ______________ the maturity; the __________ the duration of a
bond, ceteris paribus. 
 

A. larger; longer; longer

B. larger; longer; shorter
C.  smaller; shorter; longer
D. smaller; shorter; shorter
E. 
None of the options presented

 
40. You bought a stock three years ago and paid $45 per share. You collected a $2 dividend per share each year
you held the stock and then you sold the stock for $47 per share. What was your annual compound rate of
return?  
 

A. 8.89 percent
B. 8.51 percent
C.  5.84 percent
D. 4.44 percent
E.  2.96 percent
 

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41.
A four-year maturity 0 percent coupon corporate bond with a required rate of return of 12 percent has an
annual duration of _______________ years. 

 
 

A. 3.05
B. 2.97
C.  3.22
D. 3.71
E.  4.00
 
42. A decrease in interest rates will 
 

A. decrease the bond's PV.

B. increase the bond's duration.
C.  lower the bond's coupon rate.
D. change the bond's payment frequency.
E.  not affect the bond's duration.
 
43.
A 10-year maturity coupon bond has a six-year duration. An equivalent 20-year bond with the same coupon
has a duration 

 
 

A. equal to 12 years.
B. 
less than six years.

C.  less than 12 years.

D. 
equal to six years.

E.  greater than 20 years.

 

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44.
A six-year maturity bond has a five-year duration. Over the next year maturity will decline by one year and
duration will decline by 

 
 

A. less than one year.

B. more than one year.
C. 
one year.

D. N years.
E.  N/(N-1) years.
 
45. An annual payment bond has a 9 percent required return. Interest rates are projected to fall 25 basis points.
The bond's duration is 12 years. What is the predicted price change?  
 

A. -2.75 percent
B. 33.33 percent
C.  1.95 percent
D. -1.95 percent
E.  2.75 percent
 
46. A bond that pays interest annually has a 6 percent promised yield and a price of $1,025. Annual interest
rates are now projected to fall 50 basis points. The bond's duration is six years. What is the predicted new
bond price after the interest rate change? (Watch your rounding.)  
 

A. $1,042.33
B. $995.99
C.  $1,054.01
D. $987.44
E.  None of the options presented
 
47. A bond that pays interest semiannually has a 6 percent promised yield and a price of $1,045. Annual
interest rates are now projected to increase 50 basis points. The bond's duration is five years. What is the
predicted new bond price after the interest rate change? (Watch your rounding.)  
 

A. $1,020.35
B. $1,069.65
C.  $1,070.36
D. $1,019.64
E.  None of the options presented
 

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48. Convexity arises because  
 

A. bonds pay interest semiannually.

B. coupon changes are the opposite sign of interest rate changes.
C.  duration is an increasing function of maturity.
D. present values are a nonlinear function of interest rates.
E.  duration increases at higher interest rates.
 
49. The duration of a 180-day T-Bill is (in years)  
 

A. 0.493.
B. 0.246.
C.  1.
D. 0.
E.  indeterminate.
 
50. For large interest rate increases, duration _____________ the fall in security prices, and for large interest
rate decreases, duration ______________ the rise in security prices.  
 

A. overpredicts; overpredicts
B. overpredicts; underpredicts
C.  underpredicts; overpredicts
D. underpredicts; underpredicts
E.  None of the options presented
 
 

Short Answer Questions

 

51.
Is the realized rate of return related to the expected return? the required return? Explain. 

 
 

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52. Conceptually, why does a bond's price fall when required returns rise on an existing fixed income security? 
 

 
53.
A 15-year, 7 percent coupon annual payment corporate bond has a PV of $1,055.62. However, you pay
$1,024.32 for the bond. By how many basis points is your E(r) different from your r? 

 
 

 
54. What is convexity? How does convexity affect duration-based predicted price changes for interest rates
changes? 
 

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55.
An investor owned a 9 percent annual payment coupon bond for six years that was originally purchased at a
9 percent required return. She did not reinvest any coupons (she kept the money under her mattress). She
redeemed the bond at par. What was her annual realized rate of return? What if she did reinvest the
coupons but only earned 5 percent on each coupon? Why are your answers not equal to 9 percent? 

You can't use the bond price formula in this case because of the lack of reinvestment.

 
 

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56. Explain the effects of coupon and maturity on volatility. 
 

 
57.
Which would have a longer duration: (a) a five-year fully amortized installment loan with semiannual
payments or (b) a five-year semiannual payment bond, ceteris paribus. Why? 

 
 

 
58. How does an increase in interest rates affect a security's duration? 
 

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59.
An investor is considering purchasing a Treasury bond with a 16-year maturity, a 6 percent coupon and a 7
percent required rate of return. The bond pays interest semiannually.

a. What is the bond's modified duration?

b. If annual promised yields decrease 30 basis points immediately after the purchase, what is the predicted
price change in dollars based on the bond's duration?

 
 

 
60.
You have five years until you need to take your money out of your investments to make a planned
expenditure. Right now bonds are promising an 8 percent return. You buy a five-year duration bond. After
you buy the bond, interest rates fall to 6 percent and stay there for the full five years. You reinvest the
coupons and earn 6 percent. Will your realized return be more or less than the originally promised 8
percent? Explain. 

 
 

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61.
A nine-year maturity AAA-rated corporate bond has a 6 percent coupon rate. The bond's promised yield is
currently 5.75 percent and the bond sells for its FPV. The bond pays interest semiannually and has an
annual duration of 7.1023 years.

a. What is the bond's convexity?

b. If promised yields decrease to 5.45 percent, what is the bond's predicted new price, including convexity?
c. Based on your result in b, would you prefer to have a bond with more or less convexity? Explain. 

 
 

 
62.
The preferred stock of ACE pays a constant $1.00 per share dividend. The common stock of ACME just
paid a $1.00 dividend per share, but its dividend is expected to grow at 4 percent per year forever. ABLE
common stock also just paid a dividend of $1.00 per share, but its dividend is expected to grow at 10
percent per year for five years and then grow at 4 percent per year forever. All three stocks have a 12
percent required return. How much should you be willing to pay for a share of each stock? Which stock
will give you the best return? Explain. 

 
 

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 Chapter 03 Interest Rates and Security Valuation Answer Key
 

True / False Questions

 

1. If interest rates increase, the value of a fixed income contract decreases and vice versa. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-04 Appreciate how security prices are affected by interest rate changes.
Topic: Impact of Interest Rate Changes on Security Values
 
2.
At equilibrium, a security's required rate of return will be less than its expected rate of return.

 
 
FALSE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
3. If a security's realized return is negative, it must have been true that the expected return was greater than
the required return. 
 
FALSE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
4. Suppose two bonds of equivalent risk and maturity have different prices such that one is a premium
bond and one is a discount bond. The premium bond must have a greater expected return than the
discount bond. 
 
FALSE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 

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5.
A bond with an 11 percent coupon and a 9 percent required return will sell at a premium to par. 

 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
6. A fairly priced bond with a coupon less than the expected return must sell at a discount from par. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
7. All else equal, the holder of a fairly priced premium bond must expect a capital loss over the holding
period. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
8.
The duration of a four-year maturity 10 percent coupon bond is less than four years. 

 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Goal: 03-06 Know what duration is.
Topic: Duration
 
9.
The longer the time to maturity, the lower the security's price sensitivity to an interest rate change,
ceteris paribus.

 
 
FALSE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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 Blooms: Understand
Difficulty: Easy
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.
Topic: Impact of Maturity on Security Values
 
10. The greater a security's coupon, the lower the security's price sensitivity to an interest rate change,
ceteris paribus. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.
Topic: Impact of Coupon Rates on Security Values
 
11. For a given interest rate change, a 20-year bond's price change will be twice that of a 10-year bond's
price change. 
 
FALSE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.
Topic: Impact of Maturity on Security Values
 
12. Any security that returns a greater percentage of the price sooner is less price-volatile. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.
Topic: Impact of Coupon Rates on Security Values
 
13. A zero coupon bond has a duration equal to its maturity and a convexity equal to zero. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-06 Know what duration is.
Topic: Duration
 
14. The lower the level of interest rates, the greater a bond's price sensitivity to interest rate changes. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
 

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15. The higher a bond's coupon, the lower the bond's price volatility. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
 
16. Higher interest rates lead to lower bond convexity, ceteris paribus. 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Appendix 3B: More on Convexity
 
17.
A 10-year maturity zero coupon bond will have lower price volatility than a 10-year bond with a 10
percent coupon. 

 
 
TRUE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.
Topic: Impact of Coupon Rates on Security Values
 
18. Ignoring default risk, if a bond's expected return is greater than its required return, then the bond's
market price must be greater than the present value of the bond's cash flows. 
 
FALSE
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
 

Multiple Choice Questions

 

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19. The required rate of return on a bond is 
 

A.  the interest rate that equates the current market price of the bond with the present value of all future
cash flows received.
B. 
equivalent to the current yield for non-par bonds.

C. 
less than the E(r) for discount bonds and greater than the E(r) for premium bonds.

D.  inversely related to a bond's risk and coupon.

E. 
none of the options.

 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
20. Duration is 
 

A.  the elasticity of a security's value to small coupon changes.

B.  the weighted average time to maturity of the bond's cash flows.
C.  the time until the investor recovers the price of the bond in today's dollars.
D.  greater than maturity for deep discount bonds and less than maturity for premium bonds.
E. 
the second derivative of the bond price formula with respect to the YTM.

 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-06 Know what duration is.
Topic: Duration
 

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21.
Which of the following bond terms are generally positively related to bond price volatility?

I. Coupon rate
II. Maturity
III. YTM
IV. Payment frequency

 
 

A.  II and IV only

B.  I and III only
C.  II and III only
D.  II
only
E.  II, III, and IV only
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Hard
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.
Topic: Impact of Coupon Rates on Security Values
Topic: Impact of Interest Rate Changes on Security Values
Topic: Impact of Maturity on Security Values
 
22. The interest rate used to find the present value of a financial security is the 
 

A.  expected rate of return.

B.  required rate of return.
C.  realized rate of return.
D.  realized yield to maturity.
E.  current yield.
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
23. A security has an expected return less than its required return. This security is 
 

A.  selling at a premium to par.

B.  selling at a discount to par.
C.  selling for more than its PV.
D.  selling for less than its PV.
E.  a zero coupon bond.
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures

3-22
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24.
A bond that you held to maturity had a realized return of 8 percent, but when you bought it, it had an
expected return of 6 percent. If no default occurred, which one of the following must be true?

 
 

A.  The bond was purchased at a premium to par.

B. 
The coupon rate was 8 percent.

C. 
The required return was greater than 6 percent.

D.  The coupons were reinvested at a higher rate than expected.

E.  The bond must have been a zero coupon bond.
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
25.
You would want to purchase a security if P ____________ PV or E(r)  ____________ r.

 
 

A.  ≥; ≤
B.  ≥; ≥
C.  ≤; ≥
D.  ≤; ≤
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Hard
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 

3-23
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26. A 10-year annual payment corporate bond has a market price of $1,050. It pays annual interest of $100
and its required rate of return is 9 percent. By how much is the bond mispriced?  
 

A.  $0.00
B.  Overpriced by $14.18
C.  Underpriced by $14.18
D.  Overpriced by $9.32
E.  Underpriced by $9.32

PV = 100 × PVIFA [9%, 10 yrs.] + 1,000 × PVIF (9%, 10 yrs.) = $1,064.18

 
AACSB: Analytic
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Learning Goal: 03-02 Calculate bond values.
Topic: Bond Valuation
Topic: Various Interest Rate Measures
 
27. A 12-year annual payment corporate bond has a market price of $925. It pays annual interest of $60 and
its required rate of return is 7 percent. By how much is the bond mispriced?  
 

A.  $0.00
B.  Overpriced by $7.29
C.  Underpriced by $7.29
D.  Overpriced by $4.43
E.  Underpriced by $4.43

FPV = 60 × PVIFA [7%, 12 yrs.] + 1,000 × PVIF (7%, 12 yrs.) = $920.57

 
AACSB: Analytic
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Learning Goal: 03-02 Calculate bond values.
Topic: Bond Valuation
Topic: Various Interest Rate Measures
 

3-24
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28. An eight-year corporate bond has a 7 percent coupon rate. What should be the bond's price if the
required return is 6 percent and the bond pays interest semiannually?  
 

A.  $1,062.81
B.  $1,062.10
C.  $1,053.45
D.  $1,052.99
E.  $1,049.49

Price = 35.00 × PVIFA (3%, 16) + 1,000 × PVIF (3%, 16)

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Medium
Learning Goal: 03-02 Calculate bond values.
Topic: Bond Valuation
 
29. A 15-year corporate bond pays $40 interest every six months. What is the bond's price if the bond's
promised YTM is 5.5 percent?  
 

A.  $1,261.32
B.  $1,253.12
C.  $1,250.94
D.  $1,263.45
E.  $1,264.79

Using P/Y2 for semiannual; FV $1,000; PMT $40; N 15 years; and I/Y 5.5 percent. Solve bond price
(PV) = $1,253.12.

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Medium
Learning Goal: 03-02 Calculate bond values.
Topic: Bond Valuation
 
30. A corporate bond has a coupon rate of 10 percent and a required return of 10 percent. This bond's price
is  
 

A.  $924.18.
B.  $1,000.00.
C.  $879.68.
D.  $1,124.83.
E.  not possible to determine from the information given.
 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Easy

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McGraw-Hill Education.
 Learning Goal: 03-02 Calculate bond values.
Topic: Bond Valuation
 
31.
A 10-year annual payment corporate coupon bond has an expected return of 11 percent and a required
return of 10 percent. The bond's market price is 

 
 

A.  greater than its PV.

B.  less than par.
C. 
less than its E(r).

D.  less than its PV.

E. 
$1,000.00.

 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
32. An eight-year annual payment 7 percent coupon Treasury bond has a price of $1,075. The bond's annual
E(r) must be  
 

A.  13.49 percent.

B.  5.80 percent.
C.  7.00 percent.
D.  1.69 percent.
E.  4.25 percent.

$1,075 = 70 × PVIFA (E(r)%, 8) + 1,000 × PVIF (E(r)%, 8), trial and error or calculator

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 

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33. A six-year annual payment corporate bond has a required return of 9.5 percent and an 8 percent coupon.
Its market value is $20 over its PV. What is the bond's E(r)?  
 

A.  8.00 percent

B.  10.21 percent
C.  9.98 percent
D.  9.03 percent
E.  3.53 percent

PV = 933.70 = 80 × PVIFA (9.5%, 6 yrs.) + 1,000 × PVIF (9.5%, 6 yrs.); (933.70 + 20) = 80 × PVIFA
(E(r), 6 yrs.) + 1,000 × PVIF (E(r), 6 yrs.), trial and error or calculator

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Hard
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 
34. Corporate Bond A returns 5 percent of its cost in PV terms in each of the first five years and 75 percent
of its value in the sixth year. Corporate Bond B returns 8 percent of its cost in PV terms in each of the
first five years and 60 percent of its cost in the sixth year. If A and B have the same required return,
which of the following is/are true?

I. Bond A has a bigger coupon than Bond B.

II. Bond A has a longer duration than Bond B.
III. Bond A is less price-volatile than Bond B.
IV. Bond B has a higher FPV than Bond A.  
 

A.  III
only
B.  I, III, and IV only
C.  I, II, and IV only
D.  II and IV only
E.  I, II, III, and
IV
 
AACSB: Analytic
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Evaluate
Difficulty: Hard
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
Topic: Impact of Coupon Rates on Security Values
Topic: Various Interest Rate Measures
 

3-27
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35. A corporate bond returns 12 percent of its cost (in PV terms) in the first year, 11 percent in the second
year, 10 percent in the third year and the remainder in the fourth year. What is the bond's duration in
years?  
 

A.  3.68 years

B.  2.50 years
C.  4.00 years
D.  3.75 years
E.  3.32 years

3.32 = (12% * 1) + (11% * 2) + (10% * 3) + (67% * 4)

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Medium
Learning Goal: 03-06 Know what duration is.
Topic: Duration
 
36. A semiannual payment bond with a $1,000 par has a 7 percent quoted coupon rate, a 7 percent promised
YTM, and 10 years to maturity. What is the bond's duration?  
 

A.  10.00 years

B.  8.39 years
C.  6.45 years
D.  5.20 years
E.  7.35 years

Σ[(t * CFt/(1.035)t)]/(2 * $1,000)

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Hard
Learning Goal: 03-06 Know what duration is.
Topic: Duration
 

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37. An annual payment bond with a $1,000 par has a 5 percent quoted coupon rate, a 6 percent promised
YTM, and six years to maturity. What is the bond's duration?  
 

A.  5.31 years

B.  5.25 years
C.  4.76 years
D.  4.16 years
E.  3.19 years

Σ[(t*CFt/(1.06)t)]/$950.83

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Hard
Learning Goal: 03-06 Know what duration is.
Topic: Duration
 
38. If an N year security recovered the same percentage of its cost in PV terms each year, the duration
would be  
 

A.  N.
B.  0.
C.  sum of the years/N.
D.  N!/N2.
E.  none of the options.
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Hard
Learning Goal: 03-06 Know what duration is.
Topic: Duration
 
39. The ___________ the coupon and the ______________ the maturity; the __________ the duration of a
bond, ceteris paribus. 
 

A.  larger; longer; longer

B.  larger; longer; shorter
C.  smaller; shorter; longer
D.  smaller; shorter; shorter
E. 
None of the options presented

 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Hard
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
 

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40. You bought a stock three years ago and paid $45 per share. You collected a $2 dividend per share each
year you held the stock and then you sold the stock for $47 per share. What was your annual compound
rate of return?  
 

A.  8.89 percent

B.  8.51 percent
C.  5.84 percent
D.  4.44 percent
E.  2.96 percent

Use a financial calculator to solve for IRR as follows: CFO = -$45, CO1 = $2, FO1 = 1, CO2 = $2, FO2 =
1, FO3 = $47, FO3 = 1 Compute for IRR = 5.82%.

 
AACSB: Analytic
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Hard
Learning Goal: 03-03 Calculate equity values.
Topic: Equity Valuation
 
41.
A four-year maturity 0 percent coupon corporate bond with a required rate of return of 12 percent has an
annual duration of _______________ years. 

 
 

A.  3.05
B.  2.97
C.  3.22
D.  3.71
E.  4.00
 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Easy
Learning Goal: 03-06 Know what duration is.
Topic: Duration
 
42. A decrease in interest rates will 
 

A.  decrease the bond's PV.

B.  increase the bond's duration.
C.  lower the bond's coupon rate.
D.  change the bond's payment frequency.
E.  not affect the bond's duration.
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation

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 Blooms: Understand
Difficulty: Medium
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
 
43.
A 10-year maturity coupon bond has a six-year duration. An equivalent 20-year bond with the same
coupon has a duration 

 
 

A.  equal to 12 years.

B. 
less than six years.

C.  less than 12 years.

D. 
equal to six years.

E.  greater than 20 years.

 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
 
44.
A six-year maturity bond has a five-year duration. Over the next year maturity will decline by one year
and duration will decline by 

 
 

A.  less than one year.

B.  more than one year.
C. 
one year.

D.  N years.
E.  N/(N-1) years.
 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: Medium
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
 

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45. An annual payment bond has a 9 percent required return. Interest rates are projected to fall 25 basis
points. The bond's duration is 12 years. What is the predicted price change?  
 

A.  -2.75 percent

B.  33.33 percent
C.  1.95 percent
D.  -1.95 percent
E.  2.75 percent

-12 × (-0.0025/1.09)

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Medium
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Duration
 
46. A bond that pays interest annually has a 6 percent promised yield and a price of $1,025. Annual interest
rates are now projected to fall 50 basis points. The bond's duration is six years. What is the predicted
new bond price after the interest rate change? (Watch your rounding.)  
 

A.  $1,042.33
B.  $995.99
C.  $1,054.01
D.  $987.44
E.  None of the options presented

1,025 + [-6 × (-0.0050/1.06) × $1,025]

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Medium
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Duration
 

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47. A bond that pays interest semiannually has a 6 percent promised yield and a price of $1,045. Annual
interest rates are now projected to increase 50 basis points. The bond's duration is five years. What is the
predicted new bond price after the interest rate change? (Watch your rounding.)  
 

A.  $1,020.35
B.  $1,069.65
C.  $1,070.36
D.  $1,019.64
E.  None of the options presented

((-5/1.03) × 0.0050 × $1,045) + $1,045

 
AACSB: Analytic
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Medium
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Duration
 
48. Convexity arises because  
 

A.  bonds pay interest semiannually.

B.  coupon changes are the opposite sign of interest rate changes.
C.  duration is an increasing function of maturity.
D.  present values are a nonlinear function of interest rates.
E.  duration increases at higher interest rates.
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Appendix 3B: More on Convexity
 
49. The duration of a 180-day T-Bill is (in years)  
 

A.  0.493.
B.  0.246.
C.  1.
D.  0.
E.  indeterminate.

180/365

 
AACSB: Analytic
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Analyze
Blooms: Apply
Difficulty: Easy
Learning Goal: 03-06 Know what duration is.
Topic: Duration

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50. For large interest rate increases, duration _____________ the fall in security prices, and for large
interest rate decreases, duration ______________ the rise in security prices.  
 

A.  overpredicts; overpredicts

B.  overpredicts; underpredicts
C.  underpredicts; overpredicts
D.  underpredicts; underpredicts
E.  None of the options presented
 
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Duration
 
 

Short Answer Questions

 

51.
Is the realized rate of return related to the expected return? the required return? Explain. 

 
 

Yes and no. The required return determines the initial size of the coupon and the offer price and, as the r
changes, forces the market price to change. As the buy and sell prices and reinvestment rates on
coupons change, the realized return will be affected. However, the required return is an ex-ante rate
designed to compensate investors for risk. The realized return may be less than or more than the
expected or the required. That is the nature of risk. If you repeated the same investment with the same
terms over and over, you should, on average, earn a realized return equal to the required return.

 
AACSB: Analytic
AACSB: Reflective Thinking
Blooms: Analyze
Blooms: Understand
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 

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52. Conceptually, why does a bond's price fall when required returns rise on an existing fixed income
security? 
 

Since the cash flows are set by contract, the only way a new investor can expect to earn the new higher
required return is to pay less for the bond, so the price has to fall. Traders sell the existing bond in favor
of newer, higher rate bonds, dropping the price and raising the expected return.

 
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-04 Appreciate how security prices are affected by interest rate changes.
Topic: Impact of Interest Rate Changes on Security Values
 
53.
A 15-year, 7 percent coupon annual payment corporate bond has a PV of $1,055.62. However, you pay
$1,024.32 for the bond. By how many basis points is your E(r) different from your r? 

 
 

r = 6.41%

1,055.62 = 70 × [PVIFA15 yr, r] + 1,000 × [PVIFA15 yr, r]

E(r) = 6.74%

1,024.32 = 70 × [PVIFA15 yr, E(r)] + 1,000 × [PVIFA15 yr, E(r)]

E(r) is 33 basis points more than your rrr.

 
AACSB: Analytic
Blooms: Analyze
Blooms: Apply
Difficulty: Medium
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.
Topic: Various Interest Rate Measures
 

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54. What is convexity? How does convexity affect duration-based predicted price changes for interest rates
changes? 
 

Convexity is a measure of the nonlinearity (curvature) of a change in a bond's price caused by a change
in interest rates. The level of convexity increases for greater interest rate changes. Duration is a linear
estimate of a bond's price change as the interest rate changes from its current level. Due to convexity,
the greater the interest rate change, the greater the error in using duration to estimate the bond's price
change. For a multimillion-dollar bond portfolio, the dollar errors can be quite significant. In abnormal
markets, bond investors may face more or less risk than the bond's duration would imply.

Calculus Answer: Duration is the first derivative of the bond price formula with respect to a change in
interest rates. As such, it is accurate only for extremely small changes in interest rates. Duration gives
only an approximation of the actual value change for interest rate movements that are normally
observed in the market.

 
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: Hard
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Appendix 3B: More on Convexity
 

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55.
An investor owned a 9 percent annual payment coupon bond for six years that was originally purchased
at a 9 percent required return. She did not reinvest any coupons (she kept the money under her
mattress). She redeemed the bond at par. What was her annual realized rate of return? What if she did
reinvest the coupons but only earned 5 percent on each coupon? Why are your answers not equal to 9
percent? 

You can't use the bond price formula in this case because of the lack of reinvestment.

 
 

The realized returns are less than 9 percent because the investor did not reinvest the coupons at the
required rate of return. In order to earn a compound rate of return equal to the promised yield, an
investor must reinvest the coupons and earn the promised yield for the remaining time to maturity.

 
AACSB: Analytic
AACSB: Reflective Thinking
Blooms: Analyze
Blooms: Apply
Blooms: Create
Blooms: Evaluate
Difficulty: Medium
Learning Goal: 03-02 Calculate bond values.
Topic: Bond Valuation

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56. Explain the effects of coupon and maturity on volatility. 
 

The longer the maturity, the greater the price sensitivity of an asset with respect to interest rate changes.
The larger the coupon payments, or any interim cash flows, the lower the price sensitivity of an asset
with respect to asset changes. In general, any security that returns a greater proportion of an investment
more quickly will be less price-volatile because this allows the investor to respond to the interest rate
change, minimizing the opportunity cost.

 
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.
Topic: Impact of Interest Rate Changes on Security Values
 
57.
Which would have a longer duration: (a) a five-year fully amortized installment loan with semiannual
payments or (b) a five-year semiannual payment bond, ceteris paribus. Why? 

 
 

The bond will have a longer duration because you receive interest payments only until maturity,
whereas the amortizing loan pays principal and interest throughout the life of the loan. Hence, the loan
pays more (%) money back sooner. That makes the loan less volatile than the bond.

 
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: Easy
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
 
58. How does an increase in interest rates affect a security's duration? 
 

At higher interest rates the PV of more distant cash flows is reduced by a greater amount than near-term
cash flows due to compounding. For example, the PV of the 10th cash flow falls more than the PV of the
first cash flow if rates rise. This shifts a greater portion of the PV weights to the near-term cash flows,
which, in turn, results in a shorter duration. The converse is true for falling interest rates.

 
AACSB: Analytic
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty: Medium
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.
Topic: Duration
 

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59.
An investor is considering purchasing a Treasury bond with a 16-year maturity, a 6 percent coupon and
a 7 percent required rate of return. The bond pays interest semiannually.

a. What is the bond's modified duration?

b. If annual promised yields decrease 30 basis points immediately after the purchase, what is the
predicted price change in dollars based on the bond's duration?

 
 

a. The bond's price is $908.04 and the bond's modified duration is found as
Σ[(txCFt/(1.035))t]/($904.66 × 2) = 10.19 years duration;
Modified duration = 10.19/1.035 = 9.85 years
b. With a decrease of 30 basis points in annual promised yields:
Predicted D Bond Price = -9.85 × -.0030 = 2.95% or a $ price change of 0.0295 × $904.66 = $26.72

 
AACSB: Analytic
Blooms: Analyze
Blooms: Apply
Difficulty: Hard
Learning Goal: 03-06 Know what duration is.
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Duration
 
60.
You have five years until you need to take your money out of your investments to make a planned
expenditure. Right now bonds are promising an 8 percent return. You buy a five-year duration bond.
After you buy the bond, interest rates fall to 6 percent and stay there for the full five years. You reinvest
the coupons and earn 6 percent. Will your realized return be more or less than the originally promised 8
percent? Explain. 

 
 

You will earn the promised 8 percent return. Because you chose a bond with a duration equal to the
five-year time period, the loss in reinvestment income from reinvesting the coupons at 6 percent instead
of 8 percent will just be offset by having a higher-than-expected sale price of the bond in five years.

 
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: Hard
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Duration
 

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McGraw-Hill Education.
61.
A nine-year maturity AAA-rated corporate bond has a 6 percent coupon rate. The bond's promised yield
is currently 5.75 percent and the bond sells for its FPV. The bond pays interest semiannually and has an
annual duration of 7.1023 years.

a. What is the bond's convexity?

b. If promised yields decrease to 5.45 percent, what is the bond's predicted new price, including
convexity?
c. Based on your result in b, would you prefer to have a bond with more or less convexity? Explain. 

 
 

a. Bond's convexity:

b. With a new promised YTM = 5.45 percent, the YTM change is 30 basis points and the bond's new
predicted price is found as
ΔP/P = -DurMod * ΔYTM + 1/2 * CX * ΔYTM2 = (-6.90385 x -0.0030) + (½ x 58.49006 x 0.0032) =
2.09748%.
The bond's new price should be $1,017.37 + (2.09748% x $1,017.37) = $1,038.714.
c. An investor would prefer more convexity, with greater convexity or curvature; as yields drop, the
bond's price will increase more.

 
AACSB: Analytic
AACSB: Reflective Thinking
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Hard
Learning Goal: 03-08 Understand the economic meaning of duration.
Topic: Appendix 3B: More on Convexity
 

3-40
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McGraw-Hill Education.
62.
The preferred stock of ACE pays a constant $1.00 per share dividend. The common stock of ACME just
paid a $1.00 dividend per share, but its dividend is expected to grow at 4 percent per year forever.
ABLE common stock also just paid a dividend of $1.00 per share, but its dividend is expected to grow
at 10 percent per year for five years and then grow at 4 percent per year forever. All three stocks have a
12 percent required return. How much should you be willing to pay for a share of each stock? Which
stock will give you the best return? Explain. 

 
 

ACE: P = 1/0.12 = $8.33

ACME: P = 1(1.04)/(0.12-0.04) = $13.00
ABLE: D0 = $1; D1 through D5 grow at 10% per year, D6 = D5 x (1 + g2); P5 = D6/(r - g2); g2 = 4%
 

If the stocks are priced at their fair values as calculated above, all three will give the investor the same
pretax rate of return of 12 percent. A good stock buy is one where the price is less than the present value
of the expected future cash flows, regardless of the expected growth rate in the cash flows.

 
AACSB: Analytic
AACSB: Reflective Thinking
Blooms: Analyze
Blooms: Apply
Blooms: Evaluate
Difficulty: Hard
Learning Goal: 03-03 Calculate equity values.
Topic: Equity Valuation
 

3-41
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McGraw-Hill Education.