Assume a company has earnings per share of $5 and this year paid out 40% in dividends. The earnings and dividend growth rate for the next 3 years will be 20%. At the end of the third year the company will start paying out 100% of earnings in dividends and earnings will increase at an annual rate of 5% thereafter. If a 12% rate of return is required, the value of the company is approximately: A) $92.92. B) $55.69. C) $102.80. U.S. Treasury securities face several risks to varying degrees. Generally speaking, rank the following risks that an investor in a 5% coupon, 25-year, off-the-run U.S. Treasury bond, issued after 1984, would face. Order them from left to right with the least likely risk first through the most likely risk faced by the investor last. * 1 = liquidity risk. * 2 = prepayment risk. * 3 = default risk. * 4 = interest rate risk. A) 1, 2, 3, 4. B) 3, 4, 2, 1. C) 2, 3, 1, 4.
So prepayment risk is less than default risk? Aren’t they both non-existent?
Well there is absolutely ZERO chance of a Treasury bond being prepaid. That just is not possible. There is the slightest possibility that they theoretically could default. This is basically zero, but it could be possible. That is why prepayment risk would be rated less than the default risk. I believe…
Yep, the scale they use in the answers is hard to visualize. I wanted to say default risk amounts to the least risk out of any of the options, but then you would have to select B. Liquidity risk isn’t the greatest risk and pre-payment risk is a non-factor with treasuries. 2 and 3 are really a tie. If you could space them out: 2 3 1 4
For the second q I think the answer is b. Damil pl. Post the answers.
I also say C for both. Q2 is tricky…
2nd Q is C, I think. Prepayment risk only occurs with amortising securities like mortgages etc.
^ also callable bonds. i think theres the least prepayment risk in these and then default. also since its off the run theres more liquidity risk. C for me too.
I understood Q2, what is the calc for Q1?
Q1 I did like this: E0 = $5 D0 = $5 x 40% = $2 D1 = $2 x (1.2) D2 = $2 x (1.2) x (1.2) But D3 is gonna pay the full 100% out as earnings so: D3 = $5 x (1.2) x (1.2) x (1.2) From there dividends will grow at a constant rate so: D4 = D3 x (1.2) Find the PV of D1, D2 and D3 at time 0. Find the value of the stock at t =3 by using D4/k-g and then discount back to time 0. Add the 2.
Damil4real - pls post answer with calculation for the first question
is question 1 A?
answer to question 1 is C. First, calculate the dividends in years 0 through 4: (We need D4 to calculate the value in Year 3) D0 = (0.4)(5) = 2 D1 = (2)(1.2) = 2.40 D2 = (2.4)(1.2) = 2.88 D3 = E3 = 5(1.2)3 = 8.64 g after year 3 will be 5%, so D4 = 8.64 × 1.05 = 9.07 Then, solve for the terminal value at the end of period 3 = D4 / (k − g) = 9.07 / (0.12 − 0.05) = $129.57 Present value of the cash flows = value of stock = 2.4 / (1.12)1 + 2.88 / (1.12)2 + 8.64 / (1.12)3 + 129.57 / (1.12)3 = 2.14 + 2.29 + 6.15 + 92.22 = 102.80
Im an idiot i discounted the D0
the D0 is not added in. forget it.
Ah, I discounted the Year 3 DDM at (1.12)^4, not (1.12)^3. Great questions as always Damil.