Reference no: EM132924267

Question -

A) Consider a 2-year bond with an annual coupon rate of 6% that is paid semi-annually. Its annual yield-to-maturity is 5% (i.e. the semi-annual yield is 2.5%) and its face value is 1,000.

i) Calculate the price of the bond and the duration of the bond.

ii) Approximate the change in the bond price if the yield-to-maturity decreases to 4% from 5% using the bond's duration. Is the approximate price change using duration accurate? Explain.

iii) Why do bond prices go up when yields go down? Don't investors like high interest rates?

B) A fixed income fund manager predicts that interest rates will increase more than the market expects them to increase over the next year. Explain how the fund manager can take advantage of this prediction by switching between bonds of different duration. If markets are efficient will this strategy work?

C) i) Stocks A and B have expected earnings per share of $3.0 and $4.0 for the upcoming year. Given that the payout ratio for A is 60% and the payout ratio for B is 80% estimate the expected dividends to be paid by stocks A and B at the end of the year.

ii) The return on equity (ROE) for stock A and B is 9% and 12% respectively. Estimate the dividend growth rate for the two stocks.

iii) Use the infinite period dividend discount model to value stock A and B. You can assume that the estimated dividend growth will continue forever and that A has a beta of 0.8 and B has a beta of 1.2. The risk-free rate and the expected market return are 2% and 8%, respectively.