FNCE401 assignment 3

Assignment 3

Instructions
Assignment 3 should be submitted after you
have completed Unit 5. This assignment is worth
15 percent of your final grade.
Assignment 3 contains eight problems. The
maximum mark for each problem is noted at the beginning of the problem. This
assignment has a total of 100 marks.
Read the requirements for each problem and
plan your responses carefully. Although your responses should be concise,
ensure that you answer each of the required components as completely as
possible. If supporting calculations are required, present them in good form.
When you receive your graded assignment,
carefully review the comments the marker has made. This review component is an
important step in your learning process. If you have any questions or concerns
about the evaluation, please contact the Student Support Centre.

Problem 1 (10 marks)
Three years ago, you
purchased a bond for $974.69. The bond had three years to maturity, a coupon
rate of 8% paid annually, and a face value of $1,000. Each year you reinvested
all coupon interest at the prevailing reinvestment rate shown in the table
below. Today is the bond’s maturity date. What is your realized compound yield
on the bond?

Time

Prevailing reinvestment rate

0 (purchase date)

6.0%

1

7.2%

2

9.4%

3 (maturity date)

Problem 2 (15 marks)
You will be paying
$10,000 a year in education expenses at the end of the next two years.
Currently the yield curve is flat at 8%.
1.
If you want
to fully fund and immunize your obligation with a single issue of a zero-coupon
bond, what maturity bond must you purchase?

2.
What must
be the market value and the face value of the zero-coupon bond?

3.
Instead of
using a single zero-coupon bond, you prefer to use a one-year T-Bill and a
five-year zero-coupon bond to fund and immunize your obligation. How much of
each security will you buy?

Problem 3 (15 marks)
A
newly issued bond has the following characteristics:
Par value = $1000
Coupon rate = 8%
Yield to Maturity = 8%
Time to maturity = 15 years
Duration = 10 years

1.
Calculate modified duration using the information above.

2.
If the yield to maturity increases to 8.5%, what will be the
change (in dollar amount) in bond price?

3.
Identify the direction of change in modified duration if:
i. the coupon of the bond is 4%,
not 8%.
ii. the maturity of the bond is 7
years, not 15 years.
4.
How can you construct a portfolio with a duration of 8 years using
this bond and a 5 year zero coupon bond?

Problem 4 (10 marks)
You have been provided with the following
information zero coupon bonds with $1000 face value.

Maturity – semi -annual periods

semi-annual spot rates

1

4.25

2

4.15

3

3.95

4

3.70

5

3.50

6

3.25

7

3.05

8

2.90

1.
Compute the forward interest
rates.

2.
Graph the yield curve.

3.
Explain the factors that account
for the shape of the curve.

Problem 5 (10 marks)
Company HTA had a free
cash flow for the firm (FCFF) of $1,500,000 last year. It is expected the FCFF
will keep a sustainable growth rate of 5%. The company has 2 million common
shares outstanding. In addition, the following information has been gathered:
Capital structure: D/E=0.2:0.8?
Market value of Debt: VD =$5,000,000;
Required return on equity: kE =15%
Cost of debt before tax =6%
Tax rate: tc =25%;
Determine the fair
value of HTA stock.

Problem 6 (15 marks)
Company
JUK has a ROE of 25% and the company will not pay any dividend for the next 3
years. It is estimated that the company will pay $2 dividend per share after
three years and then to level off to 5% per year forever.
The
company has a beta of 2. Assume the risk-free interest rate is 4%, and the
market risk premium is 8%.
1.
What is your estimate of the fair price of a share of the stock?

2.
If the market price of a share is equal to this intrinsic value,
what is the P/E ratio?

3.
What do you expect its price to be 1 year from now? Is the implied
capital gain consistent with your estimate of the dividend yield and the market
capitalization rate?

Problem 7 (10 marks)
MicroSense, Inc., paid
$2 dividends per share last year. It is estimated that the company’s ROEs will
be 12% and 10%, respectively, next two years. The plowback rate in next two
years will be 0.6. It is expected that the dividends will grow at a sustainable
rate of 3% per year after two years. Assume that the expected return on the
market is 8%, the risk-free rate is 4%, and the beta of the stock is 1.4. What
is the fair price of the stock?

Problem 8 (15 marks):
An analyst uses the constant growth model
to evaluate a company with the following data for a company:
Leverage ratio
(asset/equity): 1.8
Total asset
turnover: 1.5
Current ratio: 1.8
Net profit margin: 8%
Dividend payout
ratio: 40%
Earnings per share
in the past year: $0.85
The required
rate on equity: 15%
Based on an analysis, the growth rate of
the company will drop by 25 percent per year in the next two years and then keep
it afterward. Assume that the company
will keep its dividend policy unchanged.
1.
Determine the growth rate of
the company for each of next three years.

2.
Use the multi-period DDM to estimate
the intrinsic value of the company’s stock.

3.
Suppose after one year,
everything else will be unchanged but the required rate on equity will decrease
to 14%. What would be your holding period return for the year?