Financial Management When Bonds Trade Essay

Excerpt from Essay :

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6. The formula for calculating the price of a zero coupon bond is

P = M / (1 + I )^n

In this case, the interest is priced to 9% and the term to 20 years. These figures are doubled, because the price of zero coupon bonds is based on semi-annual. Therefore, the price of this bond would be 1000 / (1 + .045) ^ 40 = 171.93.

7. We would use the regular bond pricing formula to calculate the YTM for this bond. This is a difficult equation to solve for, so it is typically either estimated by trial and error, or solved on a spreadsheet. Having taken the latter approach, the yield to maturity would therefore be 6.6033% for this bond.

8. To calculate the most I would be willing to pay for this preferred share investment, we must consider that the dividend is a perpetuity. The payment is quarterly, so the discount rate is adjusted accordingly to 2%. The formula for valuing a perpetuity is

P = coupon / discount rate so P = 1 / 0.02 = $50.

9. The basic formula for the dividend discount model is

P = Dividends / ( D -- G)

a) The first analyst will run a basic model that begins with the existing dividends, expected growth rate and discount rate. The current dividend is $6.60. Thus, the first analyst will value the stock as follows:

P = 6.60 / ( .11 -- .07) = $165.

b) The second analyst uses a more complicated version of the dividend discount model to value the stock. This equation must be conducted in two parts, each reflecting the different growth rates. The PV of the expected cash flows for the first three years is calculated, with the dividend discount model used to calculate the value of the remaining flows.

The first three years can be done manually, giving a total of $19.10 as the net present value of those flows. From there, the perpetuity must be calculated and this is done using the Gordon Growth model. Thus P = D / (k -- G) where'd is the future dividend, K is the discount rate and G. The future dividend growth rate. The future dividend in this case…

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