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Unformatted text preview: 1W”? :9 3’ ACTSC 371— Corporate Finance 1
Assignment 2 — Due Date Thursday February 17th, 2011 at noon Please submit your assignment in the DROP BOXES Question 1: The annual earnings of Avalanche Skis Inc will be $4 per share in perpetuity if the ﬁrm
makes no new investments. Under such a situation, the ﬁrm would pay out all of its earnings as
dividends. Assume the ﬁrst dividend will be received exactly one year from today. Alternately,
assume that in 3 years from now, and every subsequent year in perpetuity, the company can invest
25% of its earnings in new projects. Each project will earn 40% in perpetuity. The required interest
rate of the ﬁrm is 14%. (more precisely, assume the investment is made at the beginning of each year,
with the ﬁrst cash ﬂow from each project commencing at the end of the year) :93 a. What is the price per share of Avalanche if the new investments are not undertaken? b. If Avalanche announces that the new investments will be made, what will be the price per
V share be today? Question 2: Assume XYZ Inc expects to make $5.00 per share this year. XYZ pays 70% of its
earnings as dividends, and it has a historical ROE of 12%. Assume the market expects a 10% return from investing in XYZ stock.
@ (a) What is XYZ’s expected growth rate in dividends?
_ (b) What is XYZ’s current share price (Assuming the DDM)?
(3 (c) (The current P/E ratio is deﬁned as the current price divided by last year’s EPS. The forward
~ P/E is the current price divided by the expected EPS at the end of the year) The CEO of XYZ
@ believes the stock should have a forward P/E ratio of 20. What dividend policy should
achieve this? Question 3: Assume the one year spot rate is 8% and the two year spot rate is 10%. (Assume all rates
in this question are annual.) (a) What is the forward rate over year 2?
, (b) What is the price of a 2 year 12% coupon bond (annual payments)? What is the YTM on this
@ bond?
(c) Assume you purchase the bond in (b) and assume the coupon is reinvested for one year at the
@ then current spot rate of 6%. What is the annual percentage return earned on the bond
investment?
(d) In order to avoid the reinvestment risk, you decide to enter into a forward transaction to
reinvest the coupon over the second year. (i.e. you agree to reinvest the coupon at the forward
rate) What will be the effective annual total return on your bond investment under this scenario?
(e) Now suppose you purchase a 2 year zero coupon bond and sell it at the end of the ﬁrst year. Calculate:
/ i. Your percentage return if the 1 year spot rate one year from now is 9%
ii. Your percentage return if the yield curve does not change over the next year. (This
) o 'L strategy is called “riding the yield curve”)
iii. The maximum 1 year yields can be to ensure this strategy outperforms simply buying a 1 year zero coupon bond. (i) There are 2 main ways an investor can participate in the Canadian insured mortgage market:
through Mortgage Backed Securities (MBS) and through Canada Mortgage Bonds (CMB)
(both are issued via CMHC. Visit the CMHC website for more information on these
products). The primary difference between a MBS and a CMB is that a CMB pays semi
annual coupon payments and principle at maturity just like a normal bond, while MBS pay a
blend of monthly principle and interest, matching the amortization schedule of a typical
mortgage. Since some homeowners prepay amounts on their mortgages, additional cash
ﬂows may accrue to the MBS investors. Other reasons for prepayment also exist. (This pre
payment makes MBS pricing difﬁcult. See the CMHC website for some of the mathematics
on this issue). Suppose the yield curve is ﬂat at 8% and both MBS and CMB currently trade
with a YTM=8%. If you anticipate a parallel shift in the curve upwards, which would you
prefer? Why? @
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This note was uploaded on 09/14/2011 for the course STAT 371 taught by Professor Ahmed during the Spring '09 term at Waterloo.
 Spring '09
 AHMED

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