Problem 1
Bond x pays an 8% annual coupon and bond y pays a 4% annual coupon. Both bonds have 10 years to maturity. The yield to maturity for both bonds is now 8%.
If the interest rate suddenly rises by 2%, by what percentage will the price of the two bonds change?
If the interest rate suddenly drops by 2%, by what percentage will the price of the two bonds change?
Which bond has more interest rate risk? Why?
Problem 2:
Assume that you have an opportunity to buy the stock of CoolTech, Inc., an IPO being offered for $12.50 per share. Although you are very much interested in owning the company, you are concerned about whether it is fairly priced. To determine the value of the shares, you have decided to apply the free cash flow valuation model to the firm's financial data that you've developed from a variety of data sources. The key values you have compiled are summarized in the following table.
Year FCF Other data
2016 700,000 Growth rate of FCF, beyond 2019to infinity = 2%
2017 800,000 Weighted average costof capital = 8%
2018 950,000 Market value of all debt = 2,700,000
2019 1,100,000 Market value of preferred stock = $1,000,000
Use the free cash flow valuation model to estimate CoolTech's common stock value per share.
Judging on the basis of your finding in part a and the stock's offering price, should you buy the stock?
On further analysis, you find the growth rate in FCF beyond 2019 will be 3% rather than 2%. What effect would this finding have on your responses in parts a and b?
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