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Econ 479/592 STUDY QUESTIONS FOR ECONOMICS 479 Prof. Thornton Winter 2002 FINAL EXAM T, Th, 11:00-12:15 Below are 10 study questions. Six of these questions will appear on the exam. You will answer a total of four questions. One question will be required. You will then choose any 3 of the remaining 5 questions. Keep in mind that you will have one hour and thirty minutes to answer 4 test questions. This gives you about 22 minutes per question. Make sure you keep this time constraint in mind when preparing your questions. You will be allowed to bring to the test a “crib sheet” with the calculations for questions 1 and 2. However, this crib sheet must contain only numbers, it cannot have any words. 1. In April 1987, General Electric issued new AAA rated straight coupon bonds with a face value of $1,000 and annual coupon payment of $100 that mature in April 2007. You buy one of these bonds on the secondary market today and pay a price of $1,100. Calculate the coupon rate for this bond? Show your work. Why is the coupon rate not a good measure of the bond’s yield? Calculate the yield to maturity for this bond. Show your work. (Do the actual calculation with a calculator or spreadsheet such as Excel). State the two assumptions on which the yield to maturity is based? Under what circumstances is the yield to maturity a good measure of the bond’s yield? Under what circumstances might the yield to maturity be a poor measure of the bond’s yield? Given the information you have about this bond, do you think interest rates on AAA bonds are higher or lower today than they were in 1987? Justify your answer. 2. In April 2001, Lucent Technologies issued new BBB rated straight coupon bonds with a face value of $1,000 and coupon rate of 10% that matures in April 2008. These bonds have a put option to sell the bond back to Lucent at face value anytime after April 2006. You are trying to decide whether to buy one of these bonds on the secondary market. You have the following additional information. The secondary market for Lucent bonds is very active so these bonds have a high degree of liquidity. The coupon rate on newly issued Treasury inflation protected securities (TIPS) that mature in 5 years is 3%. The coupon rate on newly issued Treasury notes that mature in 5 years is 4.5%. The yield spread between Treasury securities and BBB corporate bonds is 4%. The yield on AAA corporate bonds with put options is 4.75%. The yield on AAA corporate bonds without put options is 5.00%. Given this information, what interest rate would you require to buy the Lucent bond? Carefully explain the logic you use in determining your required interest rate. To do this, discuss each factor that determines your required rate of interest and how you used the above information to measure the compensation you require for each component of your required interest rate. Given your required rate of interest, what is the maximum price you are willing to pay for the Lucent bond? Show your work and explain your logic. 3. Explain how and why each of the following events might influence the price and yield to maturity of a corporate bond traded on the secondary market. 1) Investors believe the inflation rate will increase in the future. 2) The economy falls into a recession. 3) Standard and Poor’s lowers the credit rating on the bond from A- to B. 4) The government makes interest earned on corporate bonds tax exempt. 4. What is the Treasury yield curve? Explain what might cause the Treasury yield curve to be downward sloping. What is the yield spread on a corporate bond? How is the yield spread related to the Treasury yield curve? Explain how a hedge fund might “bet on yield spreads.” Give an example. 1 5. According to the dividend discount model, what determines the true (intrinsic) value of a stock? Carefully explain the logic of this model. Do you believe this model is a useful way to think about stock prices? Yes/no. Explain. 6. According to Malkiel’s firm foundation of value model, what factors determine the true (intrinsic) value of a stock? Explain how each of these factors influence the value of a stock, and the justification or logic. Explain how Malkiel’s model is related to the dividend discount model and the earnings discount model of stock valuation? 7. You have been asked to use the relative stock valuation approach to assess whether the stock of Alliant Inc. is correctly priced relative to its competitors in the aerospace and defense industry. The market price of Alliant is currently $10 per share. You have the following information on firms in the aerospace and defense industry. P/E ratio is the price-earning ratio on a 12 month trailing basis. Expected Earnings Growth is the forecasted annual growth rate of earnings per share for the next 3 years. Beta is the beta coefficient. Dividend payout is the percent of earnings paid to stockholders in dividends for the most recent year. Expected Dividend Company P/E Ratio Earnings Growth Beta Payout United Technologies 13 16.5% 0.75 23% Lockheed Martin 10 9.5% 0.85 37% Boeing 17 3.5% 1.10 28% Honeywell 9 9.0% 1.05 47% General Dynamics 15 11.5% 1.25 40% Alliant 8 5.5% 0.95 15% Given this information, carefully explain how you would use the relative stock valuation approach to estimate the “true price” of the stock of Alliant Inc. stock. Given your estimate of the true price, is the stock correctly priced, undervalued, or overvalued? Explain. (Note: There is no right or wrong true price. What is important is the logic and explanation of the approach you use). 8. Give a concise explanation of how to use modern portfolio theory to guide you in constructing an investment portfolio. 9. You have an investment portfolio with two stocks: Citigroup and AT&T. The current market value, weight, expected return, standard deviation of return, correlation coefficient of returns, and beta coefficient for each stock and for the portfolio is given in the table below. What does the expected return, standard deviation of the return, and beta coefficient for the portfolio measure? How can the standard deviation of each individual stock be larger than the standard deviation of the portfolio which is made up of both stocks? How is this phenomenon related to the principle of diversification? Carefully explain. Does your portfolio reduce firm-specific risk? Does your portfolio reduce market risk? Explain. Market Value Weight Expected Return Standard Deviation Correlation Beta AT&T $40,000 0.40 10% 37% 0.40 1.1 Citigroup $60,000 0.60 15% 45% 0.40 1.6 Portfolio $100,000 1.0 13% 35.6% 1.4 10. Explain how the capital asset pricing model can assist you in making investment decisions. 2 Extra Question: In April 1987, General Electric issued new AAA rated straight coupon bonds with a face value of $1,000 and annual coupon payment of $100 that mature in April 2007. You buy one of these bonds on the secondary market today and pay a price of $1,100. You plan to hold this bond until it matures in April 2007. What is the total cash return you expect to make on your bond investment? What are the 3 sources of your cash return? (Note: It is possible for one source of cash return to be negative). How much cash do you expect to receive (or lose) from each source? Show your work when necessary. What assumptions did you make to do these calculations? 3

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