## 02 Aug Go to the university library and perform research on an applied case that brings the concepts learned in any chapter (or multiple) of the ones covered in this class. Make

go to the university library and perform research on an applied case that brings the concepts learned in any chapter (or multiple) of the ones covered in this class. Make sure you read the course objectives and assure you satisfy at least one of them. Cite the case, add it as an attachment, and provide a write-up connecting the case with concepts learned. The case should be from additional resources different from the book used for this class.

You can access research cases or papers in related manners, it can be a peer-reviewed article, journal, or corporate filings like 10K or 10Q.

The length is up to you. Master level quality is expected

class name Applied Managerial Finance

Chapter 7

Equity Markets and Stock Valuation

SLO: Synthesize and apply financial data to Bonds and Stock Valuations

©2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

1

Key Concepts and Skills

Understand how stock prices depend on future dividends and dividend growth.

Be able to compute stock prices using the dividend growth model.

Understand how corporate directors are elected.

Understand how stock markets work.

Understand how stock prices are quoted.

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Chapter Outline

7.1 Common Stock Valuation.

7.2 Some Features of Common and Preferred Stock.

7.3 The Stock Markets.

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Cash Flows for Stockholders

If you own a share of stock, you can receive cash in two ways.

The company pays dividends.

You sell your shares, either to another investor in the market or back to the company.

As with bonds, the price of the stock is the present value of these expected cash flows.

Dividends → cash income.

Selling → capital gains.

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One-Period Example 1

Suppose you are thinking of purchasing the stock of Moore Oil, Inc.

You expect it to pay a $2 dividend in one year.

You believe you can sell the stock for $14 at that time.

You require a return of 20% on investments of this risk.

What is the maximum you would be willing to pay?

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One-Period Example 2

D1 = $2 dividend expected in one year.

R = 20%.

P1 = $14.

CF1 = $2 + $14 = $16.

Compute the PV of the expected cash flows.

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Two-Period Example

What if you decide to hold the stock for two years?

D1 = $2.00 CF1 = $2.00.

D2 = $2.10.

P2 = $14.70.

Now how much would you be willing to pay?

CF2 = $2.10 + $14.70 = $16.80

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Three-Period Example

What if you decide to hold the stock for three years?

D1 = $2.00 CF1 = $2.00.

D2 = $2.10 CF2 = $2.10.

D3 = $2.205.

P3 = $15.435.

Now how much would you be willing to pay?

CF3 = $2.205 + $15.435 = $17.640

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Three-Period Example Using TI BAII + Cash Flow Worksheet

Cash Flows:

CF0 | = | 0 |

CF1 | = | 2.00 |

CF2 | = | 2.10 |

CF3 | = | 17.64 |

Display | You Enter | |

CF | ||

C00 | 0 | Enter, Down |

C01 | 2 | Enter, Down |

F01 | 1 | Enter, Down |

C02 | 2.10 | Enter, Down |

F02 | 1 | Enter, Down |

C03 | 17.64 | Enter, Down |

F03 | 1 | Enter, Down NPV |

I | 20 | Enter, Down CPT |

NPV 13.33 |

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Developing the Model

You could continue to push back when you would sell the stock.

You would find that the price of the stock is really just the present value of all expected future dividends.

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Stock Value = PV of Dividends

How can we estimate all future dividend payments?

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Estimating Dividends Special Cases

Constant dividend/Zero Growth.

Firm will pay a constant dividend forever.

Like preferred stock.

Price is computed using the perpetuity formula.

Constant dividend growth.

Firm will increase the dividend by a constant percent every period.

Supernormal growth.

Dividend growth is not consistent initially, but settles down to constant growth eventually.

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Zero Growth

Dividends expected at regular intervals forever = perpetuity.

P0 = D / R

Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?

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Constant Growth Stock

One whose dividends are expected togrow forever at a constant rate, g.

D1 = D0(1 + g)1

D2 = D0(1 + g)2

Dt = D0(1 + g)t

D0 = Dividend JUST PAID.

D1 to Dt = Expected dividends.

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Projected Dividends

D0 = $2.00 and constant g = 6%.

D1 = D0(1+g) = 2(1.06) = $2.12.

D2 = D1(1+g) = 2.12(1.06) = $2.2472.

D3 = D2(1+g) = 2.2472(1.06) = $2.3820.

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Dividend Growth Model

“Gordon Growth Model”

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DGM: Example 1

Suppose Big D, Inc. just paid a dividend of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for?

D0= $0.50

g = 2%

R = 15%

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DGM: Example 2

Suppose TB Pirates, Inc. is expected to pay a $2 dividend in one year. If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price?

D1 = $2.00

g = 5%

r = 20%

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Stock Price Sensitivity to Dividend Growth, g

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Stock Price Sensitivity to Required Return, R

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Example 7.3 Gordon Growth Company I

Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%.

What is the current price?

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Example 7.3 Gordon Growth Company II 1

What is the price expected to be in year 4?

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Example 7.3 Gordon Growth Company II 2

What is the implied return given the change in price during the four year period?

50.50 = 40(1 + return)4; return = 6%

4 N; −40 PV; 50.50 FV; 0 PMT; CPT I/Y = 6%

The price grows at the same rate as dividends.

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Constant Growth Model Conditions

Dividend expected to grow at g forever.

Stock price expected to grow at g forever.

Expected dividend yield is constant.

Expected capital gains yield is constant and equal to g.

Expected total return, R, must be > g.

Expected total return (R):

= expected dividend yield (DY).

+ expected growth rate (g).

= dividend yield + g.

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Nonconstant Growth

Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock?

Remember that we have to find the PV of all expected future dividends.

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Nonconstant Growth – Solution

Compute the dividends until growth levels off.

D1 = 1(1.2) = $1.20.

D2 = 1.20(1.15) = $1.38.

D3 = 1.38(1.05) = $1.449.

Find the expected future price at the beginning of the constant growth period:

P2 = D3 / (R – g) = 1.449 / (.2 − .05) = 9.66.

Find the present value of the expected future cash flows.

P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67.

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Nonconstant + Constant Growth 1

Basic PV of all Future Dividends Formula

Dividend Growth Model

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Nonconstant + Constant Growth 2

+

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Nonconstant Growth Followed by Constant Growth

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Quick Quiz: Part 1

What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%?

What if the company starts increasing dividends by 3% per year beginning with the next dividend? The required return remains at 15%.

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Using the DGM to Find R

Start with the DGM:

Rearrange and solve for R:

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Finding the Required Return Example 1

A firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year.

What is the required return?

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Finding the Required Return Example 2

P0 = $10.50.

D0 = $1.

g = 5% per year.

What is the required return?

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Finding the Required Return Example 3

P0 = $10.50.

D0 = $1.

g = 5% per year.

What is the dividend yield?

1(1.05) / 10.50 = 10%.

What is the capital gains yield?

g = 5%.

Dividend Yield

Capital Gains Yield

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Valuation Using Multiples

For stocks that don’t pay dividends (or have erratic dividend growth rates), we can value them using the price-earnings (PE) ratio and/or the price-sales ratio:

Price at time t = Pt

= Benchmark PE ratio × Earnings per sharet

Price at time t = Pt

= Benchmark price-sales ratio × Sales per sharet

The price-sales ratio can be especially useful when earnings are negative.

©2020 McGraw-Hill Education

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Valuation Using Multiples Example

Suppose we are trying to value the company Inactivision, a video game developer that does not pay dividends. If the appropriate industry PE for this type of company is 20 and you predict earnings to be $2.50 per share for the coming year, then the forecasted stock price for a year from now, or target price, is the following:

Target price = 20 × $2.50 = $50

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Table 7.1

TABLE 7.1 Summary of stock valuation

The general case

In general, the price today of a share of stock, P0, is the present value of all of its future dividends, D1, D2, D3, … :

where R is the required return.

Constant growth case

If the dividend is constant and equal to D, then the price can be written as:

If the dividend grows at a steady rate g, then the price can be written as:

This result is called the dividend growth model.

Nonconstant Growth

If the dividend grows steadily after t periods, then the price can be written as:

where:

The required return, R, can be written as the sum of two things:

R = D1 / P0 + g

where D1/P0 is the dividend yield and g is the capital gains yield (which is the same thing as the growth rate in dividends for the steady growth case).

Valuation Using Comparables

For stocks that don’t pay dividends (or have erratic dividend growth rates), we can value them using the PE ratio and/or the price-sales ratio:

Pt = Benchmark PE ratio × EPSt

Pt = Benchmark price – sales ratio × Sales per sharet

©2020 McGraw-Hill Education

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Features of Common Stock 1

Voting Rights.

Stockholders elect directors.

Cumulative voting versus Straight voting.

Boards are often staggered, or “classified.”

Proxy voting.

Classes of stock.

Founders’ shares.

Class A and Class B shares.

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Features of Common Stock 2

Other Rights.

Share proportionally in declared dividends.

Share proportionally in remaining assets during liquidation.

Preemptive right.

Right of first refusal to buy new stock issue to maintain proportional ownership if desired.

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Dividend Characteristics

Dividends are not a liability of the firm until declared by the Board of Directors.

A firm cannot go bankrupt for not declaring dividends.

Dividends and Taxes.

Dividends are not tax deductible for firm.

Taxed as ordinary income for individuals.

Dividends received by corporations have a minimum 70% exclusion from taxable income.

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Features of Preferred Stock

Dividends.

Must be paid before dividends can be paid to common stockholders.

Not a liability of the firm.

Can be deferred indefinitely.

Most preferred dividends are cumulative.

Missed preferred dividends have to be paid before common dividends can be paid.

Preferred stock generally does not carry voting rights.

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The Stock Markets

Primary versus Secondary Markets.

Primary = new-issue market.

Secondary = existing shares traded among investors.

Dealers versus Brokers.

Dealer: Maintains an inventor.

Ready to buy or sell at any time.

Think “Used car dealer.”

Broker: Brings buyers and sellers together.

Think “Real estate broker.”

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New York Stock Exchange (NYSE)

NYSE.

Merged with Euronext in 2007.

NYSE Euronext merged with the American Stock Exchange in 2008.

Members (Historically).

Buy a trading license (own a seat).

Designated market makers, DMMs (formerly known as “specialists”).

Floor brokers.

Supplemental liquidity providers (SLPs).

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NYSE Operations

Operational goal = attract order flow.

NYSE DMMs:

Assigned broker/dealer.

Each stock has one assigned DMM.

All trading in that stock occurs at the “DMM’s post.”

Trading takes place between customer orders placed with the DMMs and “the crowd.”

“Crowd”= Floor brokers and SLPs.

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NASDAQ

NASDAQ OMX (merged 2007).

Computer-based quotation system.

Multiple market makers.

Electronic Communications Networks.

Three levels of information.

Level 1 – median quotes, registered representatives.

Level 2 – view quotes, brokers & dealers.

Level 3 – view and update quotes, dealers only.

Large portion of technology stocks.

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ECNs

Electronic Communications Networks provide direct trading among investors.

Developed in late 1990s.

ECN orders transmitted to NASDAQ.

Observe live trading online at Batstrading.com.

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Reading Stock Quotes

What information is provided in the stock quote?

Click on this link to go to Bloomberg for current stock quotes.

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Work the Web

Not only are stock price quotes readily available online. Some online trading sites display their “order book” or “limit order book” live online.

The BATS Exchange was one of these websites until it was purchased by the CBOE in 2016.

Follow this link to see current buy and sell orders for Microsoft (MSFT).

©2020 McGraw-Hill Education

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Quick Quiz: Part 2 1

You observe a stock price of $18.75. You expect a dividend growth rate of 5% and the most recent dividend was $1.50. What is the required return?

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Quick Quiz: Part 2 2

What are some of the major characteristics of common stock? (Slide 38 and Slide 39).

What are some of the major characteristics of preferred stock? (Slide 41).

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Chapter 7

END

©2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

Accessibility Content: Text Alternatives for Images

©2020 McGraw-Hill Education

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Reading Stock Quotes Text Alternative

Data are listed and graphed and include previous close, open, bid, ask, day's range, 52-week range, ex-dividend date, and so on.

©2020 McGraw-Hill Education

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,

Chapter 6

Interest Rates and Bond Valuation

SLO: Synthesize and apply financial data to Bonds and Stock Valuations

©2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

1

Key Concepts and Skills

After studying this chapter, you should be able to:

Identify important bond features and types of bonds.

Describe bond values and why they fluctuate.

Discuss bond ratings and what they mean.

Evaluate the impact of inflation on interest rates.

Explain the term structure of interest rates and the determinants of bond yields.

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Chapter Outline

6.1 Bonds and Bond Valuation.

6.2 More on Bond Features.

6.3 Bond Ratings.

6.4 Some Different Types of Bonds.

6.5 Bond Markets.

6.6 Inflation and Interest Rates.

6.7 Determinants of Bond Yields.

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Bond Definitions

Bond.

Debt contract.

Interest-only loan.

Par value (face value) approximately $1,000.

Coupon rate.

Coupon payment.

Maturity date.

Yield to maturity.

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Key Features of a Bond 1

Par value:

Face amount.

Re-paid at maturity.

Assume $1,000 for corporate bonds.

Coupon interest rate:

Stated interest rate.

Usually = YTM at issue.

Multiply by par value to get coupon payment.

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Key Features of a Bond 2

Maturity:

Years until bond must be repaid.

Yield to maturity (YTM):

The market required rate of return for bonds of similar risk and maturity.

The discount rate used to value a bond.

Return if bond held to maturity.

Usually = coupon rate at issue.

Quoted as an APR.

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Bond Value

Bond Value = PV(coupons) + PV(par).

Bond Value = PV(annuity) + PV(lump sum)

Remember:

As interest rates increase present values decrease.

( r → PV )

As interest rates increase, bond prices decrease

and vice versa.

©2020 McGraw-Hill Education

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The Bond-Pricing Equation

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Texas Instruments BA-II Plus

N = number of periods to maturity.

I/Y = period interest rate = YTM.

PV = present value = bond value.

PMT = coupon payment.

FV = future value = face value = par value.

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Spreadsheet Formulas

=FV(Rate,Nper,Pmt,PV,0/1).

=PV(Rate,Nper,Pmt,FV,0/1).

=RATE(Nper,Pmt,PV,FV,0/1).

=NPER(Rate,Pmt,PV,FV,0/1).

=PMT(Rate,Nper,PV,FV,0/1).

Inside parens: (RATE,NPER,PMT,PV,FV,0/1).

“0/1” Ordinary annuity = 0 (default).

Annuity Due = 1 (must be entered).

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Pricing Specific Bonds on the TI BAII+

Bond Worksheet: 2nd BOND (above “9”).

SDT CPN RDT RV ACT 2/Y YLD PRI.

SDT = Actual Settlement date (enter MM.DDYY).

CPN = Annual rate in %.

RDT = Actual Redemption (maturity) date.

RV = Redemption value as a % of par.

ACT = ACT/360 day count setting.

2/Y = 2/Y – 1/Y coupons per year.

YLD = Yield to redemption.

PRI = Dollar price per $100 of par value.

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Pricing Specific Bonds in Excel

=PRICE(Settlement,Maturity,Rate,Yld,Redemption, Frequency,Basis).

=YIELD(Settlement,Maturity,Rate,Pr,Redemption, Frequency,Basis).

Settlement = actual date as a serial number.

Maturity = actual date as a serial number.

Redemption and Pr(ice) = % of par value.

Rate (coupon) and Yld = annual rates as decimals.

Frequency = # of coupons per year.

Basis = day count convention (enter “2” for ACT/360).

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Valuing a Discount Bond with Annual Coupons

Coupon rate = 10%

Annual coupons

Par = $1,000

Maturity = 5 years

YTM = 11%

5 | N |

11 | I/Y |

100 | PMT |

1000 | FV |

CPT PV | = − 963.04 |

Using the calculator:

Using the formula:

B = PV(annuity) + PV(lump sum)

B = 369.59 + 593.45 = 963.04

Using Excel: =PV(0.11, 5, 100, 1000, 0)

Note: When YTM > Coupon rate Price < Par = “Discount Bond”

©2020 McGraw-Hill Education

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Valuing a Premium Bond with Annual Coupons

Coupon rate = 10%

Annual coupons

Par = $1,000

Maturity = 20 years

YTM = 8%

20 | N |

8 | I/Y |

100 | PMT |

1000 | FV |

CPT PV | = − 1196.36 |

Using the calculator:

Using the formula:

B = PV(annuity) + PV(lump sum)

B = 981.81 + 214.55 = 1196.36

Using Excel: =PV(0.08, 20, 100, 1000, 0)

Note: When YTM < Coupon rate Price > Par = “Premium Bond”

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Graphical Relationship Between Price and Yield-to-Maturity

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Bond Prices: Relationship Between Coupon and Yield

Coupon rate = YTM Price = Par.

Coupon rate < YTM Price < Par.

“Discount bond” … Why?

Coupon rate > YTM Price > Par.

“Premium bond” … Why?

©2020 McGraw-Hill Education

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Bond Value ($) versus Years Remaining to Maturity

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The Bond-Pricing Equation Adjusted for Semiannual Coupons

C = Annual coupon payment | | C/2 = Semi-annual coupon |

YTM = Annual YTM (as an APR) | | YTM/2 = Semi-annual YTM |

t = Years to maturity | | 2t = Number of 6-month periods to maturity |

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Semiannual Bonds Example 6.1

Coupon rate = 14% − Semiannual.

YTM = 16% (APR).

Maturity = 7 years

Number of coupon payments? (2t or N).

14 = 2 × 7 years.

Semiannual coupon payment? (C/2 or PMT).

$70 = (14% × Face Value)/2.

Semiannual yield? (YTM/2 or I/Y).

8% = 16%/2

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Example 6.1

Semiannual coupon = $70.

Semiannual yield = 8%.

Periods to maturity = 14.

Bond value =

70[1 – 1/(1.08)14] / .08 + 1000 / (1.08)14 = 917.56.

Using Excel: =PV(0.08, 14, 70, 1000, 0).

Using the calculator:

14 | N |

8 | I/Y |

70 | PMT |

1000 | FV |

CPT PV | = −917.56 |

©2020 McGraw-Hill Education

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Interest Rate Risk 1

Price Risk.

Change in price due to changes in interest rates.

Long-term bonds have more price risk than short-term bonds.

Low coupon rate bonds have more price risk than high coupon rate bonds.

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Interest Rate Risk 2

Reinvestment Rate Risk.

Uncertainty concerning rates at which cash flows can be reinvested.

Short-term bonds have more reinvestment rate risk than long-term bonds.

High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds.

©2020 Mc

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