Module 2 – Case

Stock and Bond Valuation

Assignment Overview

Before starting on this assignment, make sure to thoroughly review
the required background materials. This assignment will require you to
use the various discounted cash flow methods and dividend models to make
computations. In addition to knowing the computational steps involved
in stock and bond valuation, make sure you also understand the basic
concepts.

Submit your answers as a Word document. Make sure to show your work
for all quantitative questions, and make sure to fully explain your
answers using references to the background readings for any conceptual
questions. Questions 1 and 3 will require Excel, so submit an Excel file
that shows your computational steps as a separate file in addition to
your Word file. Question 4 is purely conceptual, no computations are
necessary but make sure to apply and reference concepts from the
required readings in your answers to each of the scenarios.

Case Assignment

1. Suppose you buy a bond that will pay $1000 in ten years along with
   an annual coupon payment of $50 and the interest rate is 4%. Answer the
   following questions:
   1. What is the value of this bond?
   2. Now suppose the bond has no coupon payments (it is a “zero coupon”
      bond) but still pays $1000 in ten years. What is the value of this bond?
   3. What would happen to the value of the bond if the inflation rate unexpectedly goes up? What the bond value increase or decrease?
   4. Now suppose the bond still pays an annual coupon of $50 but the interest rate drops to 2%. What is the new value of this bond?
2. The XYZ Corporation pays a dividend of $1 for each share and its required rate of return is 8%. Answer the following questions:
   1. Assuming zero growth in dividends, what is the value of each share?
   2. Now assume a 4% annual growth rate in the dividend paid. What is the value of each share?
   3. Assume the growth rate is still 4%, but the required rate of return drops to 6%. What is the new value of each share?
3. Acme Medical Corp. is expecting the cash flows from 2018-2022 in the
   table below. After 2022 it is expecting growth in cash flow at an
   annual rate of 3%. The firm has determined that its weighted average
   cost of capital (discount rate) is 7%. Using the table below calculate
   the following:
   1. What is the present value of Acme’s future cash flows using the discounted cash flow model?
   2. If the firm has 200,000 common shares outstanding, zero preferred
      shares, and debt with a market value of $10,000,000 what would be the
      value of each share?
   3. Now suppose the discount rate increases to 10%. How would your answers to a) and b) above change based on the new discount rate?

1. Suppose the Alpha Manufacturing Corporation is experiencing extreme
   financial difficulties and is considering bankruptcy. Its shareholders
   are currently almost equally divided about whether or not the company
   should go bankrupt, with one outspoken faction pushing for bankruptcy
   and the other strongly opposing it. They have $50 million in debt all in
   the form of bonds, and bondholders are pretty well united in that they
   want the firm to declare bankruptcy.
   1. The CEO announces that he is leaning against bankruptcy. This means
      one faction of shareholders is happy, but another faction of
      shareholders is very upset and the bondholders are also unhappy. Can the
      unhappy faction of shareholders team up with the bondholders to vote
      out the CEO? Explain your reasoning using references from the background
      readings.
   2. Suppose Alpha ends up declaring bankruptcy. They do not have any
      cash in the bank but they own $60 million worth of real estate. They
      only have one type of shareholder—common shareholders. If they sell the
      real estate, how much of this will bondholders get and how much with
      shareholders get? Explain your reasoning using references from the
      background readings.
   3. Now suppose that Alpha has two classes of shareholders—common
      shareholders and preferred shareholders. Preferred shareholders are owed
      $20 million in dividends that have been unpaid in the last two years.
      If Alpha goes bankrupt and sells its $60 million worth of real estate,
      how much will bondholders get, how much will common shareholders get,
      and how much will preferred shareholders get? Explain your reasoning
      using references from the background readings.

Assignment Expectations

• Answer the assignment questions directly.
• Stay focused on the precise assignment questions. Do not go off on
  tangents or devote a lot of space to summarizing general background
  materials.
• For computational problems, make sure to show your work and explain your steps.
• For short answer/short essay questions, make sure to reference your
  sources of information with both a bibliography and in-text citations.
  See the Student Guide to Writing a High-Quality Academic Paper,
  including pages 11-14 on in-text citations. Another resource is the
  “Writing Style Guide,” which is found under “My Resources” in the TLC
  Portal.