Finance Midterm Notes - Midterm 1
CHAPTER 1
1.1 Corporate Finance & The Financial Manager
What is Corporate Finance?
Corporate finance is the study of ways to answer these 3 questions:
1. What long-term investments should the firm take on?
2. Where will we get the long-term financing to pay for the investment?
3. How will we manage the everyday financial activities of the firm?
Financial Managers: try to answer some or all of these questions; they represent owners’
interests and make decisions on their behalf
● Chief Financial Officer (CFO)/ Vice President: top financial manager within a firm;
coordinates the activities of the treasurer and the controller
○ Treasurer: oversees cash management, capital expenditures, and financial
planning
○ Controller: oversees taxes, cost accounting, financial accounting, and data
processing
Financial
Management
Decisions
1. Capital Budgeting: process of planning and managing a firm’s long-term investments;
What long-term investments or projects should the business take on?
● Evaluating size, timing, and risk of future cash flows
● Examples: Walmart deciding whether to open another store; Microsoft deciding
to develop and market a new spreadsheet program
2. Capital Structure: mixture of debt and equity maintained by a firm;
How should we pay for our assets? Should we use debt or equity?
● Asks: How much should the firm borrow? What are the least expensive sources of
funds for the firm?
● What % of firm’s cash flow goes to creditors and what % goes to shareholders
3. Working Capital Management: refers to short-term assets, such as inventory, and its
short-term liabilities, such as money owed to suppliers
How do we manage the day-to-day finances of the firm?
● Asks: How much cash and inventory should we keep on hand? Should we sell on
credit? How will we obtain any needed short-term financing?
1.1 Forms of Business Organization
1. Sole Proprietorship: a business owned by 1 person
● Advantages: easiest to start, least regulated, single owner keeps all the profits,
taxed once as personal income
● Disadvantages: unlimited liability, limited to life of owner, equity capital limited
to owner’s person wealth, difficult to sell ownership interest
2. Partnership (General & Limited): a business formed by 2 or more co-owners
● General Partner: have full operational control and unlimited liability
● Limited Partner: less liability and do not take part in day-to-day operations
● Advantages: 2 or more owners, more human and financial capital available,
relatively easy to start, income taxed once as personal income
● Disadvantages: unlimited liability, partnership dissolves when 1 partner dies or
wishes to sell, difficult to transfer ownership, possible disagreements between
partners
3. Corporation: a business created as a distinct legal entity owned by 1 or more individuals
or entities; most important form in USA; aka joint stock companies, public limited
companies, limited liability companies
● Public: listed on stock exchange; Private: not listed on stock exchange
● Advantages: limited liability, unlimited life, separation of ownership &
management, transfer of ownership is easy, easier to raise capital
● Disadvantages: separation of ownership & management, double taxation (income
at corporate rate and dividends at personal rate), expensive, debt finances
● To start a corporation: prepare articles of incorporation (charter) & a set of
bylaws
4. Income Trust: hold the debt and equity of an underlying business and distribute the
income generated to unit holders; aka income funds
● Advantages: not subject to corporate income tax, income is typically taxed in
hands of unit holders, investors view income trusts as more tax efficient
● Disadvantages: income trusts are not corporations and so, do not have the same
advantages as one
5. Co-operative (Co-op): enterprise that is equally owned by its members, who share the
benefits of co-operation based on how much they use the co-operative’s services
● Advantages: equally owned by its members, helps its members compete more
effectively while creating social capital
● Disadvantages: potentially difficult to reach decisions based on premise of equal
ownership by members
1.3 The Goal of Financial Management
*To maximize the current value per share of the existing stock*
1. Maximize shareholder wealth
2. Maximize share price
3. Maximize firm value
Sarbanes-Oxley Act (2002): intended to protect investors from corporate abuses; makes
company management responsible for the accuracy of financial statements
● Was created in response to corporate scandals at Enron, WorldCom, etc
● Key requirements of the act:
○ Prohibits personal loans from a company to its officers
○ Each company’s annual report must have an assessment of internal control
structure and financial reporting
○ Officers of the corporation must review and sign annual reports; must declare that
the report does not contain any false statements or material omissions
○ The annual report must list any deficiencies in internal controls
● Effect: Sarbox can be costly due to all the requirements, so hundreds of public firms
chose to “go dark” meaning their shares are no longer traded on major stock exchanges
1.4 The Agency Problem and Control of the Corporation
● Agency Relationship: relationship between stockholders and management; when
principal hired an agent to represent their interests
○ Stockholders (principals) hire managers (agents) to run the company
● Agency Problem: conflict of interest between the stockholders (principal) and
management of a firm (agent)
○ When there is a conflict between themselves and the company, they will always
choose themselves
○ Conflict of goals between employee and company
○ Example: Arthur Anderson (one of the largest accounting firms) was the auditor
of Enron, Worldcom, and Nortel. Those companies did fraudulent activities and
went bankrupt because many people sued them.
● Agency Costs: costs of the conflict of interest between stockholders and management
○ Indirect Agency Cost: if management does not take the investment, stockholders
may lose a valuable opportunity
○ Direct Agency Cost: corporate expenditure that benefits management but costs
stockholders OR an expense that arises from the need to monitor management
actions
Managing Managers
● Managerial Compensation: management will have incentives to increase share value
○ 1) Is tied to financial performance in general and to share value in particular
○ 2) Better job prospects; better performers will tend to get promoted
○ Incentives can be used to align management and stockholder interests
○ Incentives need to be structured carefully to make sure they achieve their goal
● Corporate Control: rests with stockholders who elect board of directors, hire & fire
managers
○ Threat of a takeover may result in better management
○ Proxy Fight: the authority to vote someone else’s stock; occurs when a group
solicits proxies in order to replace the existing board and managers
○ Example: Steve Jobs was founder of Apple but was fired by board of directors
● Conflicts with other Stakeholders
Social Responsibility and Ethical Investing
● Investors are demanding that corporations behave responsibly
● 4 ways a company can demonstrate corporate responsibility:
1. Employees: whether they treat their employees good or bad
a. Ex. Nike, Apple, Loblaws treats employees badly
2. Community: how they treat the community; adding or making it worse
a. Ex. There's a Walmart in every community
3. Environment: whether or not companies violate environmental laws
4. Customers: how they treat their customers
● Why DON’T companies follow social responsibility?
1. Takes time and money (net income)
2. Not a priority to shareholder/customers
3. Does not associate a direct consequence
a. Ex. Apple did not have a loss of sales
● Why do some companies EMPHASIZE social responsibility?
1. The company is built on reputation → higher sales/profits
2. Failure to follow these rules could result in lawsuits/costs
● Controversial business activities include: alcohol, gaming, genetic engineering, nuclear
power, pornography, tobacco and weapons
1.5 Financial Markets and the Corporation
● Financial Markets: debt and equity securities are bought and sold; a way of bringing
buyers and sellers together
○ Primary Market: the original sale of securities by governments and corporations
→ Corporation is the seller and the transaction raises money for the
corporation
→ Public Offering: selling securities to the general public
→ Private Placement: negotiated sale involving a specific buyer
→ Example: Tesla does an IPO (Initial public offer) which is listed on the stock
exchange and Tesla sells shares and receives cash
○ Secondary Market: those in which these securities are bought and sold after the
original sale; involves 1 owner or creditor selling to another
→ Provides the means for transferring ownership of corporate securities
→ Dealer Markets: buy and sell for themselves at their own risk
● Over-the-Counter (OTC) Market: dealer markets in stocks and longterm debt; expression refers to days of old when securities were bought
and sold at countries
→ Auction Market: has a physical location & matches those who wish to sell
with those who wish to buy
→ Example: You sell your Tesla shares to person X → Tesla doesn’t get cash
1.6 Financial Institutions
● Financial Institutions: act as intermediaries between suppliers and users of funds;
Institutions earn income on services provided
○ Indirect Finance: earn interest on the spread between loans & deposits
○ Direct Finance: service fees (ex. Bankers acceptance and stamping fees);
funds do NOT pass through the bank’s balance sheet in the form of deposit and
loan
○ Canadian financial institutions include:
■ Chartered Banks: provide other services that generate fees instead of
spread income
■ Trust Companies: accept deposits and make loans
■ Investment Dealers: non-depository institution that assists firms in
issuing new securities in enhance for fee income
■ Insurance Companies: include property and casualty insurance and
health and life insurance companies
■ Hedge Funds: less regulated and privately managed investment funds
catering to sophisticated investors seeking to earn high returns using
strategies not allowed by mutual funds
1.7 Trends in Financial Markets and Financial Management
● Financial Engineering: when financial managers or investment dealers design new
securities or financial processes; computer technology makes it practical
○ Reduces and controls risk and minimizes taxes
○ Creates debt and equity securities and reinforces the security of credit
○ Reduces costs of issuing securities and the costs of complying with rules
● Derivative Securities: useful in controlling risk, but produce large losses when
mishandled
● Advances In Technology:
○ Created e-business
○ Created opportunities to combine different types of financial institutions to take
advantage of economies of scale and scope
● Sub-Prime Market: borrowers looked to banks to provide loans at very low interest
rates for home purchases
○ Investors wanted higher returns for these low rates
○ The industry responded by issuing sum-prime mortgages and asset-backed
securities
○ People were not able to pay their mortgages
2008 Financial Crisis
In 1999-2006, the housing market of US was increasing
● For prices to increase, demand goes up, supply goes down BUT it was opposite during that time
Why did the supply for houses go up?
● A policy placed by the US government made it easier to get a loan or credit
● Lenders relaxed their strict lending standards to extend credit to people who were less than
qualified
● Easier to get credit → Demand is up —> Prices increase too → Defaults go down and back to
square one
What was the result?
● The stock market crashed in 2008 because too many had people had taken on loans they couldn’t
afford
● This drove up housing prices to levels that many could not otherwise afford
●
Banks were giving mortgages knowing people couldn't pay them, people were taking mortgages
knowing they couldn’t pay them, investment banks created this mess
● Banks were left holding trillions of dollars of worthless investments in subprime mortgages
● Banks ended up selling the mortgages to investment banks which then grouped them into asset
securities which was sold in smaller amounts to individuals
● The Great Recession that followed cost many their jobs, their savings, and their homes
What was the solution?
● The gov’t bailed out banks through 1-page contracts → gov’t bought shares off the banks
● Sarbanes-Oxley Act was placed after to prevent it from happening again
Why was the 2008 crash worse than a regular crash?
● There was no access to debt for companies
CHAPTER 5
● Present Value = earlier money on a timeline; discounting the money back to the present
● Future Value = later money on a timeline; the amount of money to which an investment
would grow over some length of time at some given interest rate
● Interest rate = “exchange rate” between earlier money and later money
○ AKA discount rate, cost of capital, opportunity cost of capital, required return
● Compound Interest: You earn interest on the interest; leaving your money and any
interest in an investment for more than one period OR reinvesting the interest
● Simple Interest: The interest is not reinvested, so interest is earned each period only on
the original principal
Compound Interest:
FV = 𝑃𝑃(1 + 𝑃)𝑃
Simple Interest:
FV = PV(1 + rt)
● FV = future value
● PV = present value
● r = period interest rate, expressed as a decimal
● t = number of periods
𝐹𝐹
PV =
r=
(1+𝐹)𝐹
(
𝐹𝐹 1
𝐹𝐹(
t=
)𝐹 − 1
𝐹𝐹
𝐹𝐹
)
𝐹𝐹
𝐹𝐹 (1+𝐹)
CHAPTER 6
Future Value - Multiple Cash Flows
1. You currently have $7,000 in a bank account earning 8% interest. You think you will be
able to deposit an additional $4,000 at the end of each of the next three years. How much
will you have in three years?
2. Suppose you invest $500 in a mutual fund today and $600 in one year. If the fund pays
9% annually, how much will you have in two years? How much will you have in 5 years
if you make no further deposits?
3. Suppose you plan to deposit $100 into an account in one year and $300 into the account
in three years. How much will be in the account in five years if the interest rate is 8%?
Present Value - Multiple Cash Flows
4. You are offered an investment that will pay you $200 in one year, $400 the next year,
$600 the year after, and $800 at the end of the following year. You can earn 12% on
similar investments. How much is this investment worth today?
5. You are considering an investment that will pay you $1000 in one year, $2000 in two
years and $3000 in three years. If you want to earn 10% on your money, how much
would you be willing to pay?
6. Your broker calls you and tells you that he has this great investment opportunity. If you
invest $100 today, you will receive $40 in one year and $75 in two years. If you require a
15% return on investments of this risk, should you take the investment?
7. You are offered the opportunity to put some money away for retirement. You will receive
five annual payments of $25,000 each beginning in 40 years. How much would you be
willing to invest today if you desire an interest rate of 12%?
8. Suppose you are looking at the following possible cash flows: Year 1 CF = $100; Years 2
and 3 CFs = $200; Years 4 and 5 CFs = $300. The required discount rate is 7%.
a. What is the value of the cash flows at year 5?
b. What is the value of the cash flows today?
c. What is the value of the cash flows at year 3?
Annuities and Perpetuities
Perpetuity:
Annuities:
Annuity
PV =
𝐹
𝐹
Perpetuity Present Value =
𝐹𝐹𝐹ℎ 𝐹𝐹𝐹𝐹
𝐹𝐹𝐹𝐹
1. After carefully going over your budget, you have determined that you can afford to pay
$632 per month towards a new sports car. Your bank will lend to you at 1% per month
for 48 months. How much can you borrow?
2. Suppose you win the Publishers Clearinghouse $10 million sweepstakes. The money is
paid in equal annual installments of $333,333.33 over 30 years. If the appropriate
discount rate is 5%, how much is the sweepstakes actually worth today?
3. You know the payment amount for a loan and you want to know how much was
borrowed. Do you compute a present value or a future value?
4. You want to receive $5,000 per month in retirement. If you can earn 0.75% per month
and you expect to need the income for 25 years, how much do you need to have in your
account at retirement?
5. Suppose you want to borrow $20,000 for a new car. You can borrow at 8% per year,
compounded monthly (8%/12 = 0.66667% per month). If you take a 4-year loan, what is
your monthly payment?
6. You ran a little short on your February vacation, so you put $1,000 on your credit card.
You can only afford to make the minimum payment of $20 per month. The interest rate
on the credit card is 1.5% per month. How long will you need to pay off the $1,000?
7. Suppose you borrow $2000 at 5% and you are going to make annual payments of
$734.42. How long before you pay off the loan?
8. Suppose you borrow $10,000 from your parents to buy a car. You agree to pay $207.58
per month for 60 months. What is the monthly interest rate?
9. You want to receive $5000 per month for the next 5 years.
a. How much would you need to deposit today if you can earn 0.75% per month?
b. What monthly rate would you need to earn if you only have $200,000 to deposit?
10. Suppose you have $200,000 to deposit and can earn 0.75% per month.
a. How many months could you receive the $5000 payment?
b. How much could you receive every month for 5 years?
11. Suppose you begin saving for your retirement by depositing $2000 per year in an RRSP.
If the interest rate is 7.5%, how much will you have in 40 years?
12. You are saving for a new house and you put $10,000 per year in an account paying 8%
compounded annually. The first payment is made today. How much will you have at the
end of 3 years?
Annuity = set duration of time
Perpetuity = forever/indefinite
Perpetuity
13. The Home Bank of Canada wants to sell preferred stock at $100 per share. A very similar
issue of preferred stock already outstanding has a price of $40 per share and offers a
dividend of $1 every quarter. What dividend would the Home Bank have to offer if its
preferred stock is going to sell?
Growing Perpetuity
Growing Perpetuity =
𝐹𝐹𝐹ℎ 𝐹𝐹𝐹𝐹
𝐹𝐹𝐹𝐹 − 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐹𝐹𝐹𝐹
14. Hoffstein Corporation is expected to pay a dividend of $3 per share next year. Investors
anticipate that the annual dividend will rise by 6% per year forever. The required rate of
return is 11%. What is the price of the stock today?
Growing Annuity:
1. Gilles Lebouder has just been offered a job at $50,000 a year. He anticipates his salary
will increase by 5% a year until his retirement in 40 years. Given an interest rate of 8%,
what is the present value of his lifetime salary?
Quiz
2. You want to have $1 million to use for retirement in 35 years. If you can earn 1% per
month, how much do you need to deposit on a monthly basis if the first payment is made
in one month? What if the first payment is made today?
3. You are considering preferred stock that pays a quarterly dividend of $1.50. If your
desired return is 3% per quarter, how much would you be willing to pay?
Pure Discount Loans
1. If a T-bill promises to repay $10,000 in 12 months and the market interest rate is 4
percent, how much will the bill sell for in the market?
2. Consider a 4-year loan with annual payments. The interest rate is 8% and the principal
amount is $5,000. What is the annual payment?
Amt = Amount of annuity
r = Interest rate
n = # of periods
R & N have to MATCH time periods
Par/Face Value = Future Value (assume $1000 if not given) | Taking a mortgage or lease is PV
R & N have to MATCH time periods
For example, a 3 year investment would mean N = 3 because it is paid annually,
But if R is:
● Compounded quarterly, then N = 3x4 = 12
● Compounded monthly, then N =3x12 = 36
Imagine your investment pays 4% interest compounded annually.
● If it was paid annually, then N = 3, R = 0.04
● If it was paid quarterly, then N = 12, R = 0.04 / 4
● If it was paid monthly, N = 36, R = 0.04 / 12
Annuity
Value of portfolio if you invest regularly →
FV = 𝐹𝐹𝐹 (
(1+𝐹)𝐹 −1
1−
Mortgage/car
→
)
𝐹
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 𝐹𝐹𝐹 (
1
(1+𝐹)
𝐹
𝐹
)
Payment made in 1 month
1−
Lease/Car Payments →
(1 + 𝐹)
Perpetuity
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐹𝐹𝐹 =
payment made today
𝐹𝐹𝐹 (
1
(1+𝐹)𝐹
𝐹
)∙
PV =
𝑃𝑃𝑃
𝑃
Cash flow = Perpetuity present value x Rate
C = PV x r
CHAPTER 7
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●
●
●
●
●
●
Bond Value = PV of coupons + PV of face
Bond Value = PV annuity + PV of lump sum
As interest rates increase the PV’s decrease and vice versa.
As interest rates increase, bond prices decrease and vice versa.
If YTM = coupon rate, then par value = bond price
If YTM > coupon rate, then par value > bond price
If YTM < coupon rate, then par value < bond price
Interest Rate Risk
○ Arises from fluctuating interest rates.
○ Two things determine how sensitive a bond will be to interest rate risk:
■ 1. Time to Maturity - All other things being equal, the longer the time to
maturity, the greater the interest rate.
■ 2. Coupon rate - All other things being equal, the lower the coupon rate,
the greater the interest rate risk.
Yield-to-maturity: rate implied by the current bond price
Bond Pricing Theorems: Bonds of similar risk (and maturity) will be priced to yield
about the same return, regardless of the coupon rate
Debt: refers to funds owed by the company towards another party called bondholders,
○ Bondholders do not have voting rights.
○ Interest is considered a cost of doing business and is tax deductible.
○ Bondholders have legal recourse if interest or principal payments are missed.
○ Excess debt can lead to financial distress and bankruptcy.
Equity: refers to an ownership interest.
○ Common shareholders vote for the board of directors and other issues.
○ Dividends are not considered a cost of doing business and are not tax deductible.
○ Dividends are not a liability of the firm and
○ shareholders have no legal recourse if dividends are not paid.
○ An all-equity firm can not go bankrupt.
The Bond Indenture: Contract between the company and the bondholders; it includes:
○ The basic terms of the bonds.
○ The total amount of bonds issued.
○ A description of property used as security, if applicable.
○ Sinking fund provisions.
○ Call provisions.
○ Details of protective covenants.
Bond Classifications
● Security:
○ Collateral - secured by financial securities.
○ Mortgage - secured by real property, normally land or buildings.
○ Debentures - unsecured debt with original maturity of 10 years or more.
○ Notes - unsecured debt with original maturity less than 10 years.
● Seniority
○ Sinking Fund - Account managed by the bond trustee for early bond redemption.
● Call Provision
○ Call premium
○ Deferred call
○ Call protected
○ Canada plus call
● Protective Covenants
○ Negative covenants
○ Positive covenants
● The coupon rate depends on the risk characteristics of the bond when issued.
● Which bonds will have the higher coupon, all else equal?
○ Secured debt versus a debenture
○ Subordinated debenture versus senior debt
○ A bond with a sinking fund versus one without
○ A callable bond versus a non-callable bond
Bond Ratings - Investment Quality
● High Grade
○ DBRS’s AAA - capacity to pay is exceptionally strong.
○ DBRS’s AA - capacity to pay is very strong.
● Medium Grade
○ DBRS’s A - capacity to pay is strong, but more susceptible to changes in
circumstances.
○ DBRS’s BBB - capacity to pay is adequate, adverse conditions will have more
impact on the firm’s ability to pay.
● Low Grade
○ DBRS’s BB, B, CCC, CC
○ Considered speculative with respect to capacity to pay.
● Very Low Grade
○ DBRS’s C - bonds are in immediate danger of default.
○ DBRS’s D - in default, with principal and/or interest in arrears.
Stripped or Zero-Coupon Bonds
● Make no periodic interest payments (coupon rate = 0%).
● The entire yield-to-maturity comes from the difference between the purchase price and
the par value.
● Cannot sell for more than par value.
● Sometimes called zeroes, or deep discount bonds.
● Bondholders must pay taxes on accrued interest every year, even though no interest is
received.
Floating Rate Bonds
● Coupon rate floats depending on some index value.
● There is less price risk with floating rate bonds
○ The coupon floats, so it is less likely to differ substantially from the yield-tomaturity.
● Coupons may have a “collar” - the rate cannot go above a specified “ceiling” or below a
specified “floor”.
Other Bond Types
● Catastrophe bonds
● Income bonds
● Convertible bonds
● Put bond (retractable bond)
Bond Markets
● Primarily over-the-counter transactions with dealers connected electronically
● Extremely large number of bond issues, but generally low daily volume in single issues
● Makes getting up-to-date prices difficult, particularly on small corporate issues
● Treasury securities are an exception
Real rate of interest: compensation for change in purchasing power
Nominal rate of interest: quoted rate of interest, includes compensation for change in
purchasing power and inflation
The Fisher Effect: defines the relationship between real rates, nominal rates and inflation
(1+R) = (1+r)(1+h)
● R = nominal rate OR total return
● r = real rate
● h = expected inflation rate
Term Structure of Interest Rates
● Term structure is the relationship between time to maturity and yields, all else equal
● It is important to recognize that we pull out the effect of default risk, different coupons,
etc.
● Yield curve - graphical representation of the term structure
○ Normal - upward-sloping, long-term yields are higher than short-term yields
○ Inverted - downward-sloping, long-term yields are lower than short-term yields
Factors Affecting Required Return
1. Default risk premium - remember bond ratings.
2. Liquidity premium - bonds that have more frequent trading will generally have lower
required returns.
3. Anything else that affects the risk of the cash flows to the bondholders, will affect the
required returns.
What to KNOW about Bonds:
● Bond prices move inversely with interest rates.
● Bonds have a variety of features that are spelled out in the indenture.
● Bonds are rated based on their default risk.
● Most bonds trade OTC.
● Fisher effect links interest rates and inflation.
● Term structure of interest rates shows the relationship between interest rates and
maturity.
● If interest rates fall, price of bonds will rise
● If interest rates rise, price of bonds will decrease
Valuing a discount bond with annual coupons
1. Consider a bond with a coupon rate of 10% and coupons paid annually. The par value is
$1,000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the
value of the bond?
2. Suppose you are looking at a bond that has a 10% annual coupon and a face value of
$1,000. There are 20 years to maturity and the yield to maturity is 8%. What is the value
of the bond?
Semiannual Coupons
3. Suppose you have an 8% semiannual-pay bond with a face value of $1,000 that matures
in 7 years. If the yield is 10%, what is the price of this bond? The bondholder receives a
payment of $40 every six months (a total of $80 per year). The market automatically
assumes that the yield is compounded semiannually. The number of semiannual periods
is 14.
The Fisher Effect
4. If we require a 10% real return and we expect inflation to be 8%, what is the nominal
rate?
Chapter 7 Textbook Questions
1. Is the yield to maturity on a bond the same thing as the required return? Is YTM the same
thing as the coupon rate? Suppose today a 10% coupon bond sells at par. Two years from
now, the required return on the same bond is 8%. What is the coupon rate on the bond
then? The YTM?
2. Suppose you buy a 7% coupon, 20-year bond today when it’s first issued. If interest rates
suddenly rise to 15%, what happens to the value of your bond? Why?
3. Malahat Inc. has 7.5% coupon bonds on the market that have ten years left to maturity.
The bonds make annual payments. If the YTM on these bonds is 8.75%, what is the
current bond price?
6. Langford Co. issued 14-year bonds a year ago at a coupon rate of 6.9%. The bonds make
semiannual payments. If the YTM on these bonds is 5.2%, what is the current bond price?
8. Happy Valley Corporation has bonds on the market with 14.5 years to maturity, a YTM of
6.1%, and a current price of $1,038. The bonds make semiannual payments. What must the
coupon rate be on these bonds?
11. An investment offers a 14% total return over the coming year. Bill Morneau thinks the total
real return on this investment will be only 9%. What does Morneau believe the inflation rate will
be over the next year?
12. Say you own an asset that had a total return last year of 10.7%. If the inflation rate last year
was 3.7%, what was your real return?
14. At the time of the last referendum, Quebec provincial bonds carried a higher yield than
comparable Ontario bonds because of investors’ uncertainty about the political future of Quebec.
Suppose you were an investment manager who thought the market was overplaying these fears.
In particular, suppose you thought that yields on Quebec bonds would fall by 50 basis points.
Which bonds would you buy or sell? Explain in words.
26. Suppose your company needs to raise $45 million and you want to issue 30-year bonds for
this purpose. Assume the required return on your bond issue will be 6%, and you’re evaluating
two issue alternatives: a 6% annual coupon bond and a zero-coupon bond. Your company’s tax
rate is 35%.
a. How many of the coupon bonds would you need to issue to raise the $45 million? How
many of the zeroes would you need to issue?
b. b. In 30 years, what will your company’s repayment be if you issue the coupon bonds?
What if you issue the zeroes?
c. c. Based on your answers in (a) and (b), why would you ever want to issue the zeroes? To
answer, calculate the firm’s aftertax cash flows for the first year under the two different
scenarios.
Lecture Question
Week 2, pg 6
1. You invest $100000 in a 5 year GIC that pays 4% interest compounded annually. What
will it be worth at the end of 5 years? What if this GIC paid 4% annual interest
compounded monthly?
Week 2, pg 8
1. You buy a house and take a mortgage of $500,000. It is repayable over 25 years and the
rate is 2%.
a. What are the monthly payments?
b. What if the interest on this mortgage was 6%, what would the maximum
mortgage be?
2. You lease a car worth $100,000 with no residue value. Lease for 5 years at 3% per year.
What are the monthly payments?
3. You take a mortgage of $500,000 to buy a home. It is repayable over 25 years and the
interest is 2% per year. What will your monthly payment be if they are due at the end of
the month?
4. You lease a new car worth $100,000 over 5 years at a lease rate of 3% per year. What
will be your monthly car payments if they are due at the beginning of each month?
Week 4, pg 2
1. An apple bond with 30 years to maturity pays an annual interest on a coupon of 3% per
year. What is the market value of the $1000 face value bond if the yield is 4%?
2. Apple issues a 30-year bond that pays an semi-annual interest on a face coupon of 3%
per year. What is the market value of the $1000 face value bond if the yield is 4%
3. Apple issues a 30-year bond that pays an annual interest on a coupon of 3% per year.
What is the market value of the $1000 face value bond next year if the yield is 4%
4. What if the bond in question 2 is convertible into 6 shares of Apple and Apple shares are
trading at $140/share?
5.