Airnova Inc. has two types of bonds, Bond D and Bond F. Both have 8 percent coupons, make semiannual payments, and are priced at par value. Bond D has 2 years to maturity. Bond F has 15 years to maturity.
Airnova Inc. is considering four different types of stocks. They each have a required return of 20 percent and a dividend of $3.75 for share. Stocks, A, B, and C are expected to maintain constant growth rates in dividends for the near future of 10 percent, 0 percent, and -5 percent, respectively. Stock D is a growth stock and will increase its dividend by 30 percent for the next four years and then maintain a constant 12 percent growth rate after that.
Discuss • If interest rates suddenly rise by 2 percent, what is the percentage change in both bonds? Since both of the bonds are sold at par, the yield to maturity is 8%, with a rate rise by 2%, it will yield to maturity at 10%. Bond D: FV=1000, PMT – 8% divided by 2 of 1000 = 40, rate = 10% divided by 2, N= 4, and the price of Bond D = 964.54. The percentage change in price = 964.54/1000-1 = -3.55% Bond F: FV=1000, PMT = 8%/2 of 1000 = 40, rate =10%/2, N=30, and the price of Bond F = 846.2755, % change in price = 846.2755/1000-1 = -15.37%
• If rates suddenly fall by 2 percent, what is the percentage change in both bonds? If the rates drop by 2%, yield to maturity =6%. Bond D: FV=1000, PMT = 8%/2 of 1000 = 40, rate = 6%/2, N=4, price of Bond D = 1037.1710, % change in price = 1027.1710/1000-1 = 3.72% Bond F: FV=1000, PMT = 6%/2 of 1000 = 40, rate = 10%/2, N = 30, price of Bond F = 846.2755, % change in price = 1196.0044/1000-1 = 19.60%
• What does this tell you about the interest rate risk of longer-term bonds? The longer the tenure of the bonds the higher is the sensitivity to interest rate risk. • What is the dividend yield for each of the four stocks? Dividend yield of A =20% - 10% = 10% Dividend yield of B = 20% - 0% = 20% Dividend yield of C = 20% - (-5%) = 25% Dividend yield of D = 20% - 30% = -10%.
Please answer the last two.
1. What is the expected capital gains yield?
2. Discuss the relationship among the various returns that you find for each of the stocks.