1. Look at the 9 1/8 percent coupon bond.

What is its current yield, its yield-

to-first call, and its yield-to-maturity?

Current Yield = Annual Coupon Interest/ Price

= 91.25/$930 = 9.812%

Annual Interest + Call Price - Market Price

No. of years to call
Yield-to-first call =
Call Price + Market Price
2

= 91.25 + {(1,104.4375 – 930) / 7}

(1,104.4375 + 930) / 2
= 116.169642857 / 1,017.21875
= 0.114203 or 11.42%

Yield to maturity (26 Years)

Approx. YTM = Call Price + {(Face Value – Market Price) / # of years}

Face Value + Market Price
= 91.25 + {(1,000 – 930) / 26}
(1,000 + 930) / 2
= 93.942307692 / 965
= 0.0973495 or 9.73%

2. Do you think this bond will be called? Why or why not?

Based on the computation above, yield to first call, 11.42% is higher than the
yield to maturity, 9.73%. Thus, a wise investor would not call this bond
because if it does, he would pay for more. It is better to wait for the maturity of
these bonds for the company to gain than to call it now.
3. What would be the value of the 9 1/8 percent coupon bond if the time to
maturity was 10 years rather than 26 years? Can you explain why your
answer is correct?

The coupon rate (coupon yield = nominal yield) is simply the coupon payment
( C ) as a percentage of the face value (F): c = C / Par Value.
Therefore, the face value of the bond is still the same, $1,000 regardless of the
time of maturity.
However, if we would solve for the yield to maturity using the revised term of 10
years, the answer would be:

Approx. YTM = Call Price + {(Face Value – Market Price) / # of years}

Face Value + Market Price
= 91.25 + {(1,000 – 930) / 10}
(1,000 + 930) / 2
= 98.25 / 965
= 0.1018134715 or 10.18%

4. What is the required rate of return for the preferred stock? How does this
rate compare to the YTM for the HPI 9 1/8 percent bond? Is this difference
what you would have expected from a risk/return standpoint? Why or why
not?

Required Rate of Return = Preferred Dividend/ Preferred Stocks Price

= $2.75/ $30
= 0.09166666 or 9.20%

The required rate of return for preferred stocks is higher than YTM for the HP1
9 1/8 bond. The reason is related with the degree of risk. As we know, preferred
stocks are riskier than bonds.

Bonds should supposedly have lower yields because it gives a lower

investment risk. However, in the case, it was determined that the Yield to
Maturity of the bonds, 9.73% is higher compared to the Required Rate of return
of the preferred stock, 9.20%. This therefore against the normal
5. In the event of liquidation, HPI preferred stockholders are entitled to
$30.50 plus accrued dividends. Does this mean that preferred
stockholders will receive that amount?

No, preferred stockholders will not automatically receive that amount.

The preferred stocks are cumulative which means that the firm cannot pay the
common stocks until it has paid all its obligations with accumulated dividends
during the previous periods. One thing is for sure though, they will be paid
before common stockholders but this does not mean that they will be paid for
the entire amount. They will receive as much as possible from the liquidation.

6. What is the dividend yield and the expected capital gains yield for HPI
common stock?

Dividend Yield = Cumulative Annual Dividend / Current Stock Price

= (0.385 x 4) / 40.625
= 3.79%
Using excel formula:
PV = 40.625; PMT = .385
Dividends/ Price = (.385*4) / 40.625 = 3.79%

Capital gain yield = (P1 – P0) / P0

= (30 + (1+0.097)-30) / 30
= 9.70%

7. Given that HPI is selling for $40 5/8, what is its required rate of return?
(Use the constant growth valuation model.)

Po= Do (1+g) / (r-g)

40.625 = 1.6894/ (X-0.097)
40.625X-3.9406-1.6894
40.625X-5.63
 Required Rate of return = 13.86%

8. Assume that the risk-free rate is 7% and that the expected return of the
market is 12%. According to the security market line valuation model,
what is the required rate of return for HPI common stock if its beta is 1.10?

rm=12%
β = 1.1
rt =?
rt =rf + ( rm. rf ) * β = 7% + (12% - 7%)*1.1
Required Rate of Return = 12.5%

9. Using the constant growth valuation model, find the present value of HPI
common stock. Would you buy or sell?

D1=$1.69
r= 12.5%
g=9.7%
Po=?

Solution:

Po = D1 1.69 $60.357
r-g 0.12-0.097

This common stock has a sale price $40 which is lower that the stock present
value. As we can see, the stock is under valuated and in this case the smart
strategy will be to buy stock with a lower price.

10. The constant growth model is used in textbooks as conceptual model to

explain changes in stock prices, Is the model also value for the actual
valuation of stocks?

The constant growth model, also known as the Gordon growth model and
dividend discount model is a method for calculating the intrinsic value of stock,
exclusive of current market conditions. The model equates this value to the
present value of stock’s future dividends. Since, the model excluded current
market value, therefore it does not reflect the actual value of the stocks.