CHAPTER 4

Solutions of End-of-Chapter Problems

4-1 DSO = 23 days; S = $3,650,000; AR = ?

AR
DSO =
S
365
AR
23 =
$3,650,000/365
23 = AR/$10,000
AR = $230,000.

4-2 Since the firm’s M/B ratio = 1, then its total market value of equity is equal to its book value of equity.

Common equity = $12 × 4,800,000 shares = $57,600,000.

Total invested capital = Debt + Equity

$110,000,000 = Debt + $57,600,000
Debt = $52,400,000.

Debt
Total debt to total capital =
Debt Equity
$52,400,000
=
$110,000,000
= 47.64%.

4-3 ROA = 11%; PM = 6%; ROE = 23%; S/TA = ?; TA/E = ?

ROA = NI/TA; PM = NI/S; ROE = NI/E.

ROA = PM S/TA
NI/TA = NI/S S/TA
11% = 6% S/TA

S/TA = 1.8333.

ROE = PM S/TA TA/E

NI/E = NI/S S/TA TA/E
23% = 6% 1.8333 TA/E
23% = 11% TA/E
TA/E = 2.091.

Chapter 4: Analysis of Financial Statements Answers and Solutions 1

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4-4 TA = $17,000,000,000; CL = $1,700,000,000; LT debt = $10,200,000,000; CE =
$5,100,000,000; Shares outstanding = 300,000,000; P0 = $20; M/B = ?

$5,100,000,000
Book value = = $17.00.
300,000,000
$20.00
M/B = = 1.1765.
$17.00
4-5 EPS = $2.40; BVPS = $21.84; M/B = 2.7 ; P/E = ?

M/B = 2.7×

P/$21.84 = 2.7×
P = $58.97.
P/E = $58.97/$2.40 = 24.57 .

4-6 NI/S = 3%; TA/E = 1.9; Sales = $150,000,000; Assets = $60,000,000; ROE = ?
ROE = NI/S S/TA TA/E

= 3% $150,000,000/$60,000,000 1.9
= 14.25%.
4-7 Given: Net income = $24,000; Common equity = $250,000

Net income

ROE =
Common equity
$24,000
= = 9.6%.
$250,000

To calculate ROIC we need to find EBIT and total invested capital.

Step 1: To calculate EBIT, we use the income statement and calculate up the income
statement beginning with net income as follows:
EBIT $45,000 EBT + Int = $40,000 + $5,000 Interest 5,000
Given
EBT $40,000 NI/(1 – T) = $24,000/0.6
Taxes (40%) 16,000 EBT × T = $40,000 × 0.4
Net income $24,000 Given
Step 2: Calculate total invested capital as follows:
Notes payable $ 27,000 Long-term
debt 75,000 Common equity 250,000
Total invested capital $352,000
Step 3: Calculate ROIC as follows:

2 Answers and Solutions Chapter 4: Analysis of Financial Statements

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 ROIC = EBIT(1 T)
Totalinvested capital
$45,000(0.6)
=
$352,000
$27,000
= = 7.67%.
$352,000
4-8 Step 1: Calculate total assets from information
given. Sales = $17 million.

3.2 = Sales/TA
$17,000,000
3.2 =
Assets
Assets = $5,312,500.

Step 2: Calculate net income.

Equity = 0.5 × Total assets = 0.5 × $5,312,500 = $2,656,250.

ROE = NI/S S/TA TA/E

0.17 = NI/$17,000,000 3.2 $5,312,500/$2,656,250
6.4NI
0.17 =
$17,000,000
$2,890,000 = 6.4NI
$451,562.50 = NI.

4-9 Calculate BEP:

ROA = 10%; Net income = $615,000; TA = ?

NI
ROA =
TA
$615,000
10%=
TA
TA = $6,150,000.
To calculate BEP, we still need EBIT. To calculate EBIT construct a partial income statement:

EBIT $ 1,081,521 $202,950 + $878,571

Interest 202,950 (Given)
EBT $ 878,571 $615,000/0.7
Taxes (30%) 263,571
NI $ 615,000

EBIT
BEP= TA
Chapter 4: Analysis of Financial Statements Answers and Solutions 3

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 $1,081,521
=
$6,150,000
= 0.1759 = 17.59%.

Calculate ROE:
We need to determine common equity from total assets calculated above and the accounts
payable and accrual balance given in the problem.

Accounts payable and accruals $ 950,000

Debt ?
Equity ?
Total claims = Total assets $6,150,000
Therefore, Debt + Equity = $5,200,000 = Total invested capital.

Debt= 0.4 × Total invested capital

= 0.4 × $5,200,000 =
$2,080,000.

Equity = 0.6 × Total invested capital

= 0.6 × $5,200,000 =
$3,120,000.

Now, we can calculate ROE as follows:

Net income $615,000
ROE = = = 19.71%.
Common equity $3,120,000

Calculate ROIC:
All the data needed in this calculation has already been determined, so just insert the numbers
into the equation:

ROIC = EBIT(1 T) = $1,081,521(0.70) = 14.56%. Totalinvested

capital $5,200,000

4-10 Stockholders’ equity = $6,500,000,000; M/B = 2.0; P = ? Total

market value = $6,500,000,000 (2) = $13,000,000,000. Market
value per share = $13,000,000,000/180,000,000 = $72.22.

Alternative solution:
Stockholders’ equity = $6,500,000,000; Shares outstanding = 180,000,000; P = ?
Book value per share = $6,500,000,000/180,000,000 = $36.11.
Market value per share = $36.11(2) = $72.22.

4-11 We are given ROA = 4% and Sales/Total assets = 1.3 .

From the DuPont equation:

4 Answers and Solutions Chapter 4: Analysis of Financial Statements

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 ROA = Profit margin Total assets turnover
4% = Profit margin(1.3)
Profit margin = 4%/1.3 = 0.030769 = 3.0769%.

Using the DuPont equation:

ROE = ROA

TA/E
8% = 4%

TA/E
TA/E = 8%/4% = 2.

Take reciprocal:
E/TA = 1/2 = 50%; since total assets = total invested capital, Equity/Total capital = 50%.

Therefore, Debt/Total invested capital = 1 – 0.5 = 50%.

Thus, the firm’s profit margin = 3.0769% and its debt-to-capital ratio = 50%.
4-12 TA = $16,000,000,000; T = 40%; EBIT/TA = 10%; ROA = 5%; TIE = ?

EBIT
= 0.10
$16,000,000,000
EBIT = $1,600,000,000.

NI
= 0.05
$16,000,000,000
NI = $800,000,000.

Now use the income statement format to determine interest so you can calculate the firm’s
TIE ratio.

EBIT $1,600,000,000 See above. INT = EBIT – EBT

INT 266,666,667 = $1,600,000,000 – $1,333,333,333

EBT $1,333,333,333 EBT = $800,000,000/0.6 Taxes (40%)

533,333,333
NI $ 800,000,000 See above.

TIE = EBIT/INT
= $1,600,000,000/$266,666,667
= 6.00×.

4-13 Calculate TIE:

TIE = EBIT/INT, so find EBIT and INT.
Interest = $600,000 0.07 = $42,000.

Net income = $2,700,000 0.07 = $189,000.

Pre-tax income (EBT) = $189,000/(1 – T) = $189,000/0.65 = $290,769.
EBIT = EBT + Interest = $290,769 + $42,000 = $332,769.
Chapter 4: Analysis of Financial Statements Answers and Solutions 5
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 Solutions to End-of-Chapter Problems

5-1 0 1 2 3 4 5
| | | | |
| 6%
PV = 2,000 FV5 = ?
5
FV5 = $2,000(1.06)
= $2,000(1.338226) = $2,676.45.

Alternatively, with a financial calculator enter the following: N = 5, I/YR = 6, PV = -2000, and
PMT = 0. Solve for FV = $2,676.45.

5-2 0 5 10 15 20
| | | |
| 5%
PV = ? FV20 = 29,000
20
PV5 = $29,000/(1.05)
= $29,000/2.6532977 = $10,929.80.

With a financial calculator enter the following: N = 20, I/YR = 5, PMT = 0, and FV = 29000.
Solve for PV = $10,929.80.

5-3 0 19
| I/YR = ? |
PV = 350,000 FV19 = 800,000

With a financial calculator enter the following: N = 19, PV = -350000, PMT = 0, and FV =
800000. Solve for I/YR = 4.4470% ≈ 4.45%.

5-4 0 N=?
| 4.0% |
PV = 1 FVN = 2
N
$2 = $1(1.04) .

With a financial calculator enter the following: I/YR = 4.0, PV = -1, PMT = 0, and FV = 2. Solve
for N = 17.67 years.

5-5 0 1 2 N–2 N–1 N

| | | | |
| 12%
PV = 33,556.25 5,000 5,000 5,000 5,000 FV = 220,000

Using your financial calculator, enter the following data: I/YR = 12; PV = -33556.25; PMT

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 = -5000; FV = 220000; N = ? Solve for N = 11. It will take 11 years to accumulate $220,000.
5-6Ordinary annuity:
0 1 2 3 4 5
| | | | |
| 5%
800 800 800 800 800
FVA5 = ?

With a financial calculator enter the following: N = 5, I/YR = 5, PV = 0, and PMT = 800. Solve
for FV = $4,420.51.

Annuity due:
0 1 2 3 4 5
5%
| | | | | |
800 800 800 800 800

With a financial calculator, switch to “BEG” and enter the following: N = 5, I/YR = 5, PV = 0,
and PMT = 800. Solve for FV = $4,641.53. Don’t forget to switch back to “END” mode.

5-7 0 1 2 3 4 5 6
| | | | | |
| 11%
150 150 150 250 300 500
PV = ? FV = ?

Using a financial calculator, enter the following: CF0 = 0; CF1 = 300; Nj = 3; CF4 = 250 (Note
calculator will show CF2 on screen.); CF5 = 300 (Note calculator will show CF3 on screen.); CF6
= 500 (Note calculator will show CF4 on screen.); and I/YR = 11. Solve for NPV = $976.60.

To solve for the FV of the cash flow stream with a calculator that doesn’t have the NFV key, do
the following: Enter N = 6, I/YR = 11, PV = -976.60, and PMT = 0. Solve for FV = $1,826.64.
You can check this as follows:
0 11% 1 2 3 4 5 6
| | | | | | |
150 150 150 250 300 500
(1.11) 333. 00
2
(1.11)
3
308.03
(1.11)
4
205.14
(1.11)
5
227.71
(1.11)
252.76
$1,826.64

5-8 Using a financial calculator, enter the following: N = 60, I/YR = 8/12 = 0.6667, PV = -40000,
and FV = 0. Solve for PMT = $811.06.

INOM M

EAR =1 M – 1.0

Chapter 5: Time Value of Money Answers and Solutions 81

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 0
|
12
= (1.00667) – 1.0
= 8.30%.

Alternatively, using a financial calculator, enter the following: NOM% = 8 and P/YR = 12. Solve
for EFF% = 8.30%. Remember to change back to P/YR = 1 on your calculator.
5-9 a. 1
? 6% = $636.00. -600 FV =
| $600(1.06)

Using a financial calculator, enter N = 1, I/YR = 6, PV = -600, PMT = 0, and FV = ? Solve

for FV = $636.00.

b. 0 1 2
| 6% | 2
| $600(1.06) = $674.16.
-600 FV = ?

Using a financial calculator, enter N = 2, I/YR = 6, PV = -600, PMT = 0, and FV = ? Solve

for FV = $674.16.

c. 0 1
| $600(1/1.06) = $566.04.
| 6%
PV = ? 600
Using a financial calculator, enter N = 1, I/YR = 6, PMT = 0, and FV = 600, and PV = ?

Solve for PV = $566.04.

d. 0 1 2

| 2
| $600(1/1.06) = $534.00.
| 6%
PV = ? 600

Using a financial calculator, enter N = 2, I/YR = 6, PMT = 0, FV = 600, and PV = ? Solve for
PV = $534.00.

5-10 a. 0 1 2 3 4 5 6 7 8 9 10
4% | | | | | | | | 10
| | | $200(1.04) = $296.05.
-200 FV = ?
Using a financial calculator, enter N = 10, I/YR = 4, PV = -200, PMT = 0, and FV = ? Solve

for FV = $296.05.
b. 01 2 3 4 5 6 7 8 9 10

8% | | | | | | | | 10
| | | $200(1.08) = $431.78.
-200 FV = ?
Using a financial calculator, enter N = 10, I/YR = 8, PV = -200, PMT = 0, and FV = ? Solve

for FV = $431.78.

82 Answers and Solutions Chapter 5: Time Value of Money

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 c. 01 2 3 4 5 6 7 8 9 10
| | | | | | | | | 10
| $200/(1.04) = $135.11.
| 4%
PV = ? 200
Using a financial calculator, enter N = 10, I/YR = 4, PMT = 0, FV = 200, and PV = ? Solve

for PV = $135.11.

Chapter 5: Time Value of Money Answers and Solutions 83

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 0
|

d. 12 3 4 5 6 7 8 9 10
| | | | | | |
8% |
| | PV = ? 1,870.00
10
$1,870.0/(1.08) = $866.17.

Using a financial calculator, enter N = 10, I/YR = 8, PMT = 0, FV = 1870.00, and PV

= ? Solve for PV = $866.17.

10
$1,870.00/(1.04) = $1,263.30.

Using a financial calculator, enter N = 10, I/YR = 4, PMT = 0, FV = 1870.00, and PV

= ? Solve for PV = $1,263.30.

e. The present value is the value today of a sum of money to be received in the
future. For example, the value today of $1,870.00 to be received 10 years in the
future is $866.17 at an interest rate of 8%, but it is $1,263.30 if the interest rate is
4%. Therefore, if you had $866.17 today and invested it at 8%, you would end up
with $1,870.00 in 10 years. The present value depends on the interest rate
because the interest rate determines the amount of interest you forgo by not
having the money today.

5-11 a. 2010 2011 2012 2013 2014 2015

?
| | | | | |
-2.5 5 (in millions)

With a calculator, enter N = 5, PV = -2.5, PMT = 0, FV = 5, and then solve for I/YR
= 14.87%.

b. The calculation described in the quotation fails to consider the compounding effect of
5
interest. It can be demonstrated to be incorrect as follows: $2,500,000(1.20)
= $2,500,000(2.48832)= $6,220,800,

which is greater than $5 million. Thus, the annual growth rate is less than 20%; in fact, it
is about 15%, as shown in part a.

5-12 These problems can all be solved using a financial calculator by entering the known values
shown on the time lines and then pressing the I/YR button.

a. 0 1
| I/YR = ? |
+720 -792

With a financial calculator, enter: N = 1, PV = 720, PMT = 0, and FV = -792. I/YR = 10%.

b. 0 1

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 | I/YR = ? |
-720 +792

With a financial calculator, enter: N = 1, PV = -720, PMT = 0, and FV = 792. I/YR = 10%.

c. I/YR = ? 14
|
+65,000 -98,319
With a financial calculator, enter: N = 14, PV = 65000, PMT = 0, and FV = -98319. I/YR =

3%.
d. 0 I/YR = ? 1 2 3 4 5

| | | | | |
+15,000 -4,058.60 -4,058.60 -4,058.60 -4,058.60 -4,058.60
With a financial calculator, enter: N = 5, PV = 15000, PMT = -4058.60, and FV = 0. I/YR =

11%.
5-13 a. 6% ?

| |
-300 600

With a financial calculator, enter I/YR = 6, PV = -300, PMT = 0, and FV = 600. Then press
the N key to find N = 11.90. Override I/YR with the other values to find N = 5.67, 3.64, and
1.00.

b. 13% ?
| | Enter: I/YR = 13, PV = -300, PMT = 0, and FV = 600.
-300 600 N = 5.67.
c. 21% ?

| | Enter: I/YR = 21, PV = -300, PMT = 0, and FV = 600.

-300 600 N = 3.64.
d. ?
100%
| | Enter: I/YR = 100, PV = -300, PMT = 0, and FV = 600.
-300 600 N = 1.00.
5-14a. 0 14% 1 2 3 4 5 6 7 8

| | | | | | | | |
500 500 500 500 500 500 500 500
FV = ?

With a financial calculator, enter N = 8, I/YR = 14, PV = 0, and PMT = -500. Then press the
FV key to find FV = $6,616.38.

b. 0 7% 1 2 3 4
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 0
|

| | | | |
250 250 250 250
FV = ?

With a financial calculator, enter N = 4, I/YR = 7, PV = 0, and PMT = -250. Then press the
FV key to find FV = $1,109.99.
c. 0 1 2 3 4
| 0% | | | |
700 700 700 700
FV = ?

With a financial calculator, enter N = 4, I/YR = 0, PV = 0, and PMT = -700. Then press the
FV key to find FV = $2,800.

d. To solve part d using a financial calculator, repeat the procedures discussed in parts a,
b, and c, but first switch the calculator to “BEG” mode. Make sure you switch the
calculator back to “END” mode after working the problem.

1. 0 1 2 3 4 5 6 7 8
14%
| | | | | | | | |
500 500 500 500 500 500 500 500 FV = ?
With a financial calculator on BEG, enter: N = 8, I/YR = 14, PV = 0, and PMT = -500.

FV = $7,542.67.
2. 0 1 2 3 4

| 7% | | | |
250 250 250 250 FV = ?
With a financial calculator on BEG, enter: N = 4, I/YR = 7, PV = 0, and PMT = -250.

FV = $1,187.68.
3. 0 1 2 3 4

| 0% | | | |
700 700 700 700 FV = ?
With a financial calculator on BEG, enter: N = 4, I/YR = 0, PV = 0, and PMT = -700. FV

= $2,800.
5-15 a. 0 1 2 3 4 5 6 7 8 9 10 11 12

| | | | | | | | | | | |
| 8%
PV = ? 600 600 600 600 600 600 600 600 600 600 600 600
With a financial calculator, simply enter the known values and then press the key for the

unknown. Enter: N = 12, I/YR = 8, PMT = -600, and FV = 0. PV = $4,521.65.

b. 0 1 2 3 4 5 6

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 | 4% | | | | | |
PV = ? 300 300 300 300 300 300
With a financial calculator, enter: N = 6, I/YR = 4, PMT = -300, and FV = 0. PV =

$1,572.64.
c. 0 0% 1 2 3 4 5 6

| | | | | | |
PV = ? 500 500 500 500 500 500
With a financial calculator, enter: N = 6, I/YR = 0, PMT = -500, and FV = 0. PV =

$3,000.00.

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 d. 1. 0 1 2 3 4 5 6 7 8 9
10 11 12
| 8% | | | | | | | | | | | |
600 600 600 600 600 600 600 600 600 600 600 600
PV = ?
With a financial calculator on BEG, enter: N = 12, I/YR = 8, PMT = -600, and FV = 0.

PV = $4,883.38.
2. 0 1 2 3 4 5 6

| 4% | | | | | |
300 300 300 300 300 300
PV = ?
With a financial calculator on BEG, enter: N = 6, I/YR = 4, PMT = -300, and FV = 0.

PV = $1,635.55.
3. 0 1 2 3 4 5 6

| 0% | | | | | |
500 500 500 500 500 500
PV = ?
With a financial calculator on BEG, enter: N = 6, I/YR = 0, PMT = -500, and FV = 0. PV

= $3,000.00.

5-16 PV5% = $600/0.05 = $12,000. PV10% = $600/0.10 = $6,000.

When the interest rate is doubled, the PV of the perpetuity is halved.

5-17 0 1 2 3 4 30
| I/YR = ?| | | | |
230,000 -20,430.31 -20,430.31 -20,430.31 -20,430.31 -20,430.31

With a calculator, enter N = 30, PV = 230000, PMT = -20430.31, FV = 0, and then solve for I/YR
= 8%.

5-18 a. Cash Stream A Cash Stream B | | | | | | | |

| | | |
0 1 2 3 4 5 0 1 2 3 4 5
5% 5%
PV = ? 150 450 450 450 250 PV = ? 250 450 450 450 150

With a financial calculator, simply enter the cash flows (be sure to enter CF 0 = 0), enter I/YR
= 5, and press the NPV key to find NPV = PV = $1,505.84 for the first problem. Override
I/YR
= 5 with I/YR = 0 to find the next PV for Cash Stream A. Enter the cash flows for Cash
Stream B, enter I/YR = 5, and press the NPV key to find NPV = PV = $1,522.73.
Override I/YR = 5 with I/YR = 0 to find the next PV for Cash Stream B.

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 b. PVA = $150 + $450 + $450 + $450 + $250 = $1,750.

PVB = $250 + $450 + $450 + $450 + $150 = $1,750.

5-19 a. Begin with a time line:

26 27 64 65
| | |
| 10%
8,000 8,000 8,000
FV = ?

Using a financial calculator input the following: N = 39, I/YR = 10, PV = 0, PMT = 8000,
and solve for FV = $3,211,582.22.

b. 26 27 69 70
10%
| | | |
8,000 8,000
8,000
FV = ?
Using a financial calculator input the following: N = 44, I/YR = 10, PV = 0, PMT = 8000,

and solve for FV = $5,221,126.09.

c. 1. 65 66 67 84 85

10%
| | | | |
3,211,582.22 PMT PMT PMT PMT
Using a financial calculator, input the following: N = 20, I/YR = 10, PV = -3211582.22,

FV = 0, and solve for PMT = $377,231.24.

2. 70 71 72 84 85

| | | |
| 10%
5,221,126.09 PMT PMT PMT PMT
Using a financial calculator, input the following: N = 15, I/YR = 10, PV = -5221126.09,

FV = 0, and solve for PMT = $686,441.17.

5-20 Contract 1: PV = $3,000,000 $3,000,0002 $3,000,0003 $3,000,0004

1.07 (1.07) (1.07) (1.07)

= $2,803,738.32+$2,620,316.18+$2,448,893.63 + $2,288,685.64
= $10,161,633.77.

Using your financial calculator, enter the following data: CF0 = 0; CF1-4 = 3000000; I/YR = 7;
NPV = ? Solve for NPV = $10,161,633.77.

$2,000,000 $3,000,000 $4,500,000 $5,500,000

Contract 2: PV = 2 3

1.07 (1.07) (1.07) (1.07) 4

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 = $1,869,158.88 + $2,620,316.18 + $3,673,340.45 + $4,195,923.67
= $12,358,739.18.

Alternatively, using your financial calculator, enter the following data: CF 0 = 0; CF1 =
2000000; CF2 = 3000000; CF3 = 4500000; CF4 = 5500000; I/YR = 7; NPV = ? Solve for NPV
= $12,358,739.18.

$7,000,000 $1,000,000 $1,000,000 $1,000,000

Contract 3: PV= 2 3

1.07 (1.07) (1.07) (1.07) 4

= $6,542,056.07 + $873,438.73 + $816,297.88 + $762,895.21

= $8,994,687.89.
Alternatively, using your financial calculator, enter the following data: CF 0 = 0; CF1 =
7000000; CF2 = 1000000; CF3 = 1000000; CF4 = 1000000; I/YR = 7; NPV = ? Solve for NPV
= $8,994,687.89.

Contract 2 gives the quarterback the highest present value; therefore, he should accept Contract
2.

5-21 a. If Kristina expects a 7% annual return on her investments:

1 payment 10 payments 30 payments N = 10N
= 30
I/YR = 7 I/YR = 7
PMT = 9500000 PMT = 5600000
FV = 0 FV = 0
PV = $62,000,000 PV = $66,724,024.64 PV = $69,490,630.63

Kristina should accept the 30-year payment option as it carries the highest present
value ($69,490,630.63).

b. If Kristina expects an 8% annual return on her investments:

1 payment 10 payments 30 payments N = 10N
= 30
I/YR = 8 I/YR = 8
PMT = 9500000 PMT = 5600000
FV = 0 FV = 0
PV = $62,000,000 PV = $63,745,773.29 PV = $63,043,586.72

Kristina should accept the 10-year payment option as it carries the highest present
value ($63,745,773.29).

c. If Kristina expects a 9% annual return on her investments:

1 payment 10 payments 30 payments N = 10N
= 30
I/YR = 9 I/YR = 9
PMT = 9500000 PMT = 5600000
FV = 0 FV = 0
PV = $62,000,000 PV = $60,967,748.16 PV = $57,532,462.64
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 Kristina should accept the lump-sum payment option as it carries the highest present
value ($62,000,000).

d. The higher the interest rate, the more useful it is to get money rapidly, because it can be
invested at those high rates and earn lots more money. So, cash comes fastest with #1,
slowest with #3, so the higher the rate, the more the choice is tilted toward #1. You can
also think about this another way. The higher the discount rate, the more distant cash flows
are penalized, so again, #3 looks worst at high rates, #1 best at high rates.

5-22 a. This can be done with a calculator by specifying an interest rate of 5% per period for 20
periods with 1 payment per period.

N = 10 2 = 20, I/YR = 10/2 = 5, PV = -10000, FV = 0. Solve for PMT = $802.43.

b. Set up an amortization table:
Beginning Payment of Ending
Period Balance Payment Interest Principal Balance
1 $10,000.00 $802.43 $500.00 $302.43 $9,697.57
484.88
2 9,697.57 802.43 $984.88 317.55 9,380.02

Because the mortgage balance declines with each payment, the portion of the payment
that is applied to interest declines, while the portion of the payment that is applied to
principal increases. The total payment remains constant over the life of the mortgage.

c. Jan must report interest of $984.88 on Schedule B for the first year. Her interest income will
decline in each successive year for the reason explained in part b.

d. Interest is calculated on the beginning balance for each period, as this is the amount the
lender has loaned and the borrower has borrowed. As the loan is amortized (paid off), the
beginning balance, hence the interest charge, declines and the repayment of principal
increases.

5-23 a. 0 1 2 3 4 5
| | | | |-
| 12%
500 FV = ?

With a financial calculator, enter N = 5, I/YR = 12, PV = -500, and PMT = 0, and then
press FV to obtain FV = $881.17.

b. 0 1 2 3 4 5 6 7 8 9 10
| 6% | | | | | | | | | |
-500 FV = ?

With a financial calculator, enter N = 10, I/YR = 6, PV = -500, and PMT = 0, and then
press FV to obtain FV = $895.42.

I 0.12 5(2)
Alternatively, FVN = PV1 NOMM NM = $5001 2

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 10
= $500(1.06) = $895.42.
c. 0 4 8 12 16 20

| 3% | | | | |
-500 FV = ?

With a financial calculator, enter N = 20, I/YR = 3, PV = -500, and PMT = 0, and then
press FV to obtain FV = $903.06.

Alternatively, FVN = $500 1 + 0.12 5(4)

20
= $500(1.03) = $903.06.

4
d. 0 12 24 36 48 60

| 1% | | | | |
-500 FV = ?
With a financial calculator, enter N = 60, I/YR = 1, PV = -500, and PMT = 0, and then press
FV to obtain FV = $908.35.
Alternatively, FVN = $500 1+ 0.12 5(12) = $500(1.01)
60
= $908.35.

12 e.
0 365 1,825

| 0.0329% | |

-500 FV = ?

With a financial calculator, enter N = 1825, I/YR = 12/365 = 0.032877, PV = -500, and
PMT = 0, and then press FV to obtain FV = $910.97.

0.12 5(365) 1,825

Alternatively, FVN = $500 1+ = $500(1.00032877) = $910.97.
365

f. The FVs increase because as the compounding periods increase, interest is earned on
interest more frequently.

5-24 a. 0 2 4 6 8 10
| 6% | | | | |
PV = ? 500

With a financial calculator, enter N = 10, I/YR = 6, PMT = 0, and FV = 500, and then
press PV to obtain PV = $279.20.

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 Alternatively, PV = FVN 1NOM NM =
$500 1+01.12/2 5(2)

1+I /M

= $500 1 10
= $279.20.
1.06

b. 0 4 8 12 16 20

| 3% | | | | |
PV = ? 500

With a financial calculator, enter N = 20, I/YR = 3, PMT = 0, and FV = 500, and then
press PV to obtain PV = $276.84.

Alternatively, PV = $500 1 +01.12/4 4(5) = $500 1.013 20 =

$276.84.
c. 0 1% 1 2 12

| | | |
PV = ? 500

With a financial calculator, enter N = 12, I/YR = 1, PMT = 0, and FV = 500, and then
press PV to obtain PV = $443.72.

Alternatively, PV = $500 1 +0.112/12 12(1) = $500 1.011 12 =

$443.72.
d. The PVs for parts a and b decline as periods per year increase. This occurs because, with
more frequent compounding, a smaller initial amount (PV) is required to get to $500 after
5 years. For part c, even though there are 12 periods/year, compounding occurs over
only 1 year, so the PV is larger.

5-25 a. 0 1 2 3 9 10
| | | | |
6% |
-400 -400 -400 -400 -400
FV = ?

Enter N = 5 2 = 10, I/YR = 12/2 = 6, PV = 0, PMT = -400, and then press FV to get FV =
$5,272.32.

b. Now the number of periods is calculated as N = 5 4 = 20, I/YR = 12/4 = 3, PV = 0, and

PMT = -200. The calculator solution is $5,374.07. The solution assumes that the nominal
interest rate is compounded at the annuity period.

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 Solutions to End-of-Chapter Problems

6-1 a. Term Rate 9%

6 months 4.69% 8%
1 year 5.49 2 years 5.66 7%
3 years 5.71 6%
4 years 5.89 5%
5 years 6.05 10 years 6.12 4%
20 years 6.64 3%
30 years 6.76 2%
1%
0%
0 5 10 15 20 25 30
b. The yield curve shown is an Years to Maturity upward
sloping yield curve.

c. This yield curve tells us generally that either inflation is expected to increase or there is
an increasing maturity risk premium.

d. Even though the borrower reinvests in increasing short-term rates, those rates are still
below the long-term rate, but what makes the higher long-term rate attractive is the rollover
risk that may possibly occur if the short-term rates go even higher than the long-term rate
(and that could be for a long time!). This exposes you to rollover risk. If you borrow for 30
years outright you have locked in a 6.76% interest rate each year.

6-2 T-bill rate = r* + IP

5.8% = r* + 3.25% r*
= 2.55%.

6-3 r* = 2.25%; I1 =
2.5%; I2 = 4.25%; I3 =
4.25%; MRP = 0; rT2 =
?; rT3 = ?

r = r* + IP + DRP + LP + MRP.

Since these are Treasury securities, DRP = LP = 0.

rT2 = r* + IP2.

IP2= (2.5% + 4.25%)/2 = 3.375%.

rT2 = 2.25% + 3.375% = 5.625%.
rT3 = r* + IP3.

IP3= (2.5% + 4.25% + 4.25%)/3 = 3.67%.

rT3 = 2.25% + 3.67% = 5.92%.
6-4 rT10 = 5.75%; rC10 = 8.75%; LP = 0.35%; DRP = ?
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 r = r* + IP + DRP + LP + MRP. rT10 = 5.75% =
r* + IP10 + MRP10; DRP = LP = 0. rC10 = 8.75% =
r* + IP10 + DRP + 0.35% + MRP10.

Because both bonds are 10-year bonds the inflation premium and maturity risk premium on both
bonds are equal. The only difference between them is the liquidity and default risk premiums.

rC10 = 8.75% = r* + IP10 + MRP10 + 0.35% + DRP. But we know from above that r* + IP10 +
MRP10 = 5.75%; therefore,

rC10 = 8.75% = 5.75% + 0.35% + DRP

2.65% = DRP.

6-5 r* = 2.5%; IP2 = 2.75%; rT2 = 5.55%; MRP2 = ?

rT2 = r* + IP2 + MRP2 = 5.55% rT2 =

2.5% + 2.75% + MRP2 = 5.55% MRP2 =
0.3%.

6-6 r* = 5%; IP4 = 18%; MRP = DRP = LP = 0; rRF4 = ?

rRF4 = (1 + r*)(1 + IP4) –

1 = (1.05)(1.18) – 1
= 0.239 = 23.9%.

6-7 rT1 = 4.85%; 1rT1 = 5.2%; rT2 = ?

2
(1 + rT2) = (1.0485)(1.052)
2
(1 + rT2) = 1.103022
1 + rT2 = 1.05024854
rT2 = 5.02%.

6-8 Let X equal the yield on 2-year securities 4 years from now:
4 2 6
(1.067) (1 + X) = (1.0725)
2
(1.2961572)(1 + X) = 1.5218919
1+X= 1.5218919 1/2

1.2961572
X = 8.36%.

6-9 r7 = r* + IP7 + MRP7 + DRP + LP.

r* = 0.0205.
IP7 = [0.0305 + 0.0475 + (5)(0.023)]/7 = 0.0276.
MRP7 = 0.0005(t – 1) = 0.0005(6) = 0.003.
DRP = 0.
LP = 0.
rT7 = r* + IP7 + MRP7 rT7 = 0.0205 + 0.0276 +
0.003 = 0.0511 = 5.11%.

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6-10 Basic relevant equations:
rt = r* + IPt + DRPt + MRPt + IPt.

But here IPt is the only premium, so rt = r* + IPt.

IPt = Avg. inflation = (I1 + I2 + . . .)/N.

We know that I1 = IP1 = 3.25% and r* = 2.5%. Therefore, rT1 = 2.5% +

3.25% = 5.75%. rT3 = rT1 + 1.5% = 5.75% + 1.5% = 7.25%. But, rT3 = r* +

IP3 = 2.5% + IP3 = 7.25%, so IP3 = 7.25% – 2.5% = 4.75%.

We also know that It = Constant after t = 1.

We can set up this table:

r* I IPt r = r* + IPt
12.5% 3.25% 3.25%/1 = 3.25% 5.75%
2 2.5% I(3.25% + I)/2 = IP2
3 2.5% I(3.25% + I + I)/3 = IP3 rT3 = 7.25%, so IP3 = 7.25% – 2.5% = 4.75%.

IP3 = (3.25% + 2I)/3 = 4.75%

2I= 11%
I= 5.5%.

6-11 We’re given all the components to determine the yield on the bonds except the default risk
premium (DRP) and MRP. Calculate the MRP as 0.1%(5 – 1) = 0.4%. Now, we can solve for
the DRP as follows:
7.00% = 2.75% + 2.05% + 0.4% + 0.7% + DRP, or DRP = 1.10%.

6-12 First, calculate the inflation premiums for the next three and five years, respectively. They are
IP3 =
(2.1% + 2.7% + 3.65%)/3 = 2.82% and IP5 = (2.1% + 2.7% + 3.65% + 3.65% + 3.65%)/5
= 3.15%. The real risk-free rate is given as 1.95%. Since the default and liquidity premiums are
zero on Treasury bonds, we can now solve for the maturity risk premium. Thus, 5.2% = 1.95%
+ 2.82% + MRP3, or MRP3 = 0.43%. Similarly, 6.0% = 1.95% + 3.15% + MRP5, or MRP5 =
0.90%. Thus, MRP5 – MRP3 = 0.90% – 0.43% = 0.47%.

6-13 rC11 = r* + IP11 + MRP11 + DRP11 + LP11

8.7% = 1.7% + (1.5% 4 + 4.8% 7)/11 + 0.0% + DRP11 + 0.3%
8.7% = 1.7% + 3.6% + 0.0% + DRP11 +
0.3% 8.7% = 5.6% + DRP11 DRP11 = 3.10%.
2
6-14 a. (1.041) = (1.032)(1 + X)
1.083681/1.032 = 1 + X
X = 5%.

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 b. For riskless bonds under the expectations theory, the interest rate for a bond of any maturity
is rN = r* + average inflation over N years. If r* = 1%, we can solve for IP N:
Year 1: r1 = 1% + I1 = 3.2%;
I1 = expected inflation = 3.2% – 1% = 2.2%.

Year 2: r1 = 1% + I2 = 5.00%;
I2 = expected inflation = 5.00% – 1% = 4%.

Note also that the average inflation rate is (2.2% + 4%)/2 = 3.1%, which, when added
to r* = 1%, produces the yield on a 2-year bond, 4.1%. Therefore, all of our results are
consistent.

6-15 r* = 2%; MRP = 0%; rT1 = 5%; rT2 = 7%; X = ?

X represents the one-year rate on a bond one year from now (Year 2).
2
(1.07) = (1.05)(1 + X)
1.
= 1+

X X = 9%.

9% = r* + I2
9% = 2% + I2
7% = I2.

The average interest rate during the 2-year period differs from the 1-year interest rate expected
for Year 2 because of the inflation rate reflected in the two interest rates. The inflation rate
reflected in the interest rate on any security is the average rate of inflation expected over the
security’s life.

6-16 rRF6 = 20.84%; MRP = DRP = LP = 0; r* = 6%; IP 6 = ?

rRF6 = (1 + r*)(1 +IP6) – 1

20.84% = (1.06)(1 + IP6) – 1
1.2084 = (1.06)(1 + IP6)
1.14 = 1 + IP6 0.14 =
IP6.

6-17 rT5 = 5.2%; rT10 = 6.4%; rC10 = 8.4%; IP10 = 2.5%; MRP = 0. For Treasury securities, DRP = LP =
0.

DRP5 + LP5 = DRP10 + LP10. rC5 = ?

rT10 = r* + IP10
6.4% = r* + 2.5%
r* = 3.9%.

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 rT5 = r* + IP5
5.2% = 3.9% + IP5
1.3% = IP5.

rC10 = r* + IP10 + DRP10 + LP10 8.4% = 3.9% + 2.5% + DRP10 + LP10 2%

= DRP10 + LP10. rC5 = 3.9% + 1.3% + DRP5 + LP5, but DRP5 + LP5 =
DRP10 + LP10 = 2%. So,

rC5 = 3.9% + 1.3% + 2%

= 7.2%.

6-18 a. Years to Real Risk-Free

Maturity Rate (r*) IPt** MRP rT = r* + IPt + MRPt
1 2% 7.00% 0.2% 9.20%
2 2 6.00 0.4 8.40
3 2 5.00 0.6 7.60
4 2 4.50 0.8 7.30
5 2 4.20 1.0 7.20 10 2 3.60 1.0 6.60
20 2 3.30 1.0 6.30

**The computation of the inflation premium is as follows:

Expected
Year Inflation IPt
1 7% 7.00%
2 5 6.00
3 3 5.00
4 3 4.50
5 3 4.20 10 3 3.60
20 3 3.30

For example, the calculation for IP3 is as follows:

IP3 = 7% 5% 3% = 5.00%.
3

Thus, the yield curve would be as follows:

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 Solutions to End-of-Chapter Problems

7-1 With your financial calculator, enter the following:

N = 23; I/YR = YTM = 11%; PMT = 0.09 1,000 = 90; FV = 1000; PV = VB = ?

PV = $834.67.

7-2 VB = $980; M = $1,000; Int = 0.08 $1,000 = $80.

a. N = 12; PV = -980; PMT = 80; FV = 1000; YTM = ?

Solve for I/YR = YTM = 8.2691% 8.27%.

b. N = 9; I/YR = 8.2691; PMT = 80; FV = 1000; PV

= ? Solve for VB = PV = $983.38.

7-3 The problem asks you to find the price of a bond, given the following facts: N = 2 14 = 28;
I/YR = 11/2 = 5.5; PMT = (0.08/2) × 1,000 = 40; FV = 1000.

With a financial calculator, solve for PV = $788.18.

7-4 With your financial calculator, enter the following to find YTM:

N = 8 2 = 16; PV = -1283.09; PMT = 0.11/2 1,000 = 55; FV = 1000; I/YR = YTM = ?

YTM = 3.21% 2 = 6.42%.

With your financial calculator, enter the following to find YTC:

N = 4 2 = 8; PV = -1283.09; PMT = 0.11/2 1,000 = 55; FV = 1154; I/YR = YTC = ?
YTC = 3.16% 2 = 6.32%.

Since the YTC is less than the YTM, investors would expect the bonds to be called and to earn
the YTC. (The bonds sell at a premium indicating that interest rates have declined since the
bonds were issued; therefore, the bonds would likely be called if interest rates remain lower than
the coupon rate.)

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 7-5 a. 1. 6%: Bond L: Input N = 12, I/YR = 6, PMT = 110, FV = 1000, PV = ?,
PV = $1,419.19. Bond S: Change N = 1, PV = ? PV = $1,047.17.

2. 8%: Bond L: From Bond S inputs, change N = 12 and I/YR = 8, PV = ?, PV =

$1,226.08.
Bond S:Change N = 1, PV = ? PV = $1,027.78.

3. 12%: Bond L: From Bond S inputs, change N = 12 and I/YR = 12, PV = ?, PV =

$938.06.
Bond S:Change N = 1, PV = ? PV = $991.07.

b. Think about a bond that matures in one month. Its present value is influenced primarily by
the maturity value, which will be received in only one month. Even if interest rates double,
the price of the bond will still be close to $1,000. A 1-year bond’s value would fluctuate
more than the one-month bond’s value because of the difference in the timing of receipts.
However, its value would still be fairly close to $1,000 even if interest rates doubled. A long-
term bond paying semiannual coupons, on the other hand, will be dominated by distant
t
receipts, receipts that are multiplied by 1/(1 + rd/2) , and if rd increases, these multipliers will
decrease significantly. Another way to view this problem is from an opportunity point of
view. A 1-month bond can be reinvested at the new rate very quickly, and hence the
opportunity to invest at this new rate is not lost; however, the long-term bond locks in
subnormal returns for a long period of time.

7-6 a. Time Years to Maturity Price of Bond C Price of Bond Z

t = 0 4 $1,108.82 $ 729.61 t = 1 3 1,084.74 789.44 t = 2 2 1,058.69 854.17
t=3 1 1,030.50 924.21
t=4 0 1,000.00 1,000.00

Bond Price Paths

$1,200.00 Bond C
$1,000.00
$800.00 Bond Z

$600.00
$400.00

$200.00

$0.00
0 1 2 3 4

b. Time

7-7 Percentage

Price at 8% Price at 7% Change

10-year, 10% annual coupon $1,134.20 $1,210.71 6.75%
10-year zero 463.19 508.35 9.75 5-year zero 680.58 712.99 4.76 30-year zero
99.38 131.37 32.19
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 $100 perpetuity 1,250.00 1,428.57 14.29

7-8 The rate of return is approximately 11.75%, found with a calculator using the following
inputs: N = 7; PV = -1000; PMT = 110; FV = 1075; I/YR = ? Solve for I/YR = 11.75%.

Despite an 11.75% return on the bonds, investors are not likely to be happy that they were
called. Because if the bonds have been called, this indicates that interest rates have fallen
sufficiently that the YTC is less than the YTM. (Since they were originally sold at par, the YTM at
issuance = 11%.) Rates are sufficiently low to justify the call. Now investors must reinvest their
funds in a much lower interest rate environment.
7-9 a. VB = N INT t M
t 1 (1 rd ) (1 rd )N

M = $1,000. PMT = 0.10($1,000) = $100.

1. VB = $865: Input N = 6, PV = -865, PMT = 100, FV = 1000, YTM = I/YR = ? I/YR =

13.42%.

2. VB = $1,166: Change PV = -1166, YTM = I/YR = ? I/YR = 6.56%.

b. Yes. At a price of $865, the yield to maturity, 13.42%, is greater than your required rate of
return of 12%. If your required rate of return were 12%, you should be willing to buy the
bond at any price below $917.77.

7-10 a. Solving for YTM:

N = 9, PV = -910.30, PMT = 90, FV = 1000
I/YR = YTM = 10.5946% 10.595%.

b. The current yield is defined as the annual coupon payment divided by the current price.

CY = $90/$910.30 = 9.8869% 9.887%.

Expected capital gains yield can be found as the difference between YTM and the
current yield.

CGY = YTM – CY = 10.595% – 9.887% = 0.708% 0.71%.

Alternatively, you can solve for the capital gains yield by first finding the expected price
next year. N = 8, I/YR = 10.5946, PMT = 90, FV = 1000 PV = -$916.74. V B = $916.74.

Hence, the capital gains yield is the percentage price appreciation over the next year.

CGY = (P1 – P0)/P0 = ($916.74 – $910.30)/$910.30 = 0.708% 0.71%.

c. As rates change they will cause the end-of-year price to change and thus the realized
capital gains yield to change. As a result, the realized return to investors will differ from
the YTM.

Chapter 7: Bonds and Their Valuation Answers and Solutions 109

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7-11 a. Using a financial calculator, input the following to solve for YTM:
N = 18, PV = -1200, PMT = 65, FV = 1000, and solve for YTM = I/YR = 4.813867%.

However, this is a periodic rate. The nominal YTM = 4.813867%(2) = 9.627733% 9.63%.

For the YTC, input the following:

N = 12, PV = -1200, PMT = 65, FV = 1065, and solve for YTC = I/YR = 4.697409%.

However, this is a periodic rate. The nominal YTC = 4.697409%(2) = 9.394817% 9.39%.

So the bond is likely to be called, and investors are most likely to earn a 9.39% yield.
(The bond sells at a premium indicating that interest rates have declined since the bond
was issued; therefore, the bond would likely be called if interest rates remain lower than
the coupon rate.)
b. The current yield = $130/$1,200 = 10.83%.
The current yield will remain the same;
however, if the bond is called the YTC
reflects the total return (rather than the YTM)
so the capital gains yield will be different.

c. YTM = Current yield + Capital gains (loss) yield

9.63% = 10.83% + Capital loss yield -1.20%
= Capital loss yield.

This is the capital loss yield if the YTM is expected.

However, based on our calculations in part a, the total return expected would actually be the
YTC = 9.39%. So, the expected capital loss yield = 9.39% – 10.83% = -1.44%.

7-12 a. Yield to maturity (YTM):

With a financial calculator, input N = 28, PV = -1191.20, PMT = 80, FV = 1000, I/YR
= ? I/YR = YTM = 6.50%.

Yield to call (YTC):

With a calculator, input N = 3, PV = -1191.20, PMT = 80, FV = 1080, I/YR = ? I/YR = YTC
= 3.72%.

b. Knowledgeable investors would expect the return to be closer to 3.7% than to 6.5%. If
interest rates remain substantially lower than 8%, the company can be expected to call the
issue at the call date and to refund it with an issue having a coupon rate lower than 8%.
(The bond sells at a premium indicating that interest rates have declined since the bond was
issued. So, if interest rates remain lower than the coupon rate the bond will likely be called.)

c. If the bond had sold at a discount, this would imply that current interest rates are above the
coupon rate (i.e., interest rates have risen). Therefore, if interest rates remained at levels at
or above the coupon rate the company would not call the bonds, so the YTM would be more
relevant than the YTC.

7-13 The problem asks you to solve for the YTM and Price, given the following facts:

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114 Integrated Case Chapter 7: Bonds and Their Valuation
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Chapter 8 Risk and Rates of ReturN
Solutions to End-of-Chapter Problems

8-1 ˆr = (0.1)(-30%) + (0.1)(-14%) + (0.3)(11%) + (0.3)(20%) +

(0.2)(45%) = 13.90%.
2 2 2
2= (-30% – 13.90%) (0.1) + (-14% – 13.90%) (0.1) + (11% – 13.90%) (0.3)
2 2
+ (20% – 13.90%) (0.3) + (45% – 13.90%) (0.2)
2
= 447.69; = 21.86%.
21.86%
CV = = 1.57.
13.90%
8-2Investment Beta 75,0002.5

$20,000 0.6
Total $95,000

bp = ($20,000/$95,000)(0.6) + ($75,000/$95,000)(2.5) = 2.10.

8-3 rRF = 5.5%; rM = 12%; b = 2; r = ?

r = rRF + (rM – rRF)b = 5.5%

+ (12% – 5.5%)2.0 =
18.50%.

8-4 rRF = 3.5%; RPM = 4%; rM = ?

rM = 3.5% + (4%)1.0 = 7.5%.

r when b = 0.8 = ? r =

3.5% + (4%)0.8 = 6.7%.

8-5 a. r = 9%; rRF = 4.5%; RPM = 3%.

r = rRF + (rM – rRF)b

9% = 4.5% + 3%b
4.5% = 3%b
b = 1.5.
b. rRF = 4.5%; RPM = 5%; b = 1.5.

Chapter 8: Risk and Rates of Return Answers and Solutions 115

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 r = rRF + (rM – rRF)b
= 4.5% + (5%)1.5
= 12%.

8-6 a. ˆr Piri .
i 1

ˆrB = 0.1(-35%) + 0.2(0%) + 0.4(20%) + 0.2(25%) + 0.1(45%)

= 14% versus 12% for A.

b. = (ri ˆr)2 Pi .
i 1

2 2 2
σ2A = (-10% – 12%) (0.1) + (2% – 12%) (0.2) + (12% – 12%) (0.4)
2 2
+ (20% – 12%) (0.2) + (38% – 12%) (0.1) = 148.8.

A = 12.20% versus 20.35% for B. CVA =

A/ˆr A = 12.20%/12% = 1.02, while

CVB = 20.35%/14% = 1.45.

If Stock B is less highly correlated with the market than A, then it might have a lower beta
than Stock A, and hence be less risky in a portfolio sense.

8-7 Portfolio beta= $460,000 (1.50) + $500,000 (-0.50) + $1,260,000 (1.25) + $2,600,000 (0.75)
$4,820,000 $4,820,000 $4,820,000 $4,820,000
bp = (0.0954)(1.5) + (0.1037)(-0.50) + (0.2614)(1.25) +
(0.5394)(0.75) = 0.1431 + -0.0519 + 0.3268 + 0.4046 = 0.8226.

rp = rRF + (rM – rRF)(bp) = 4% + (8% – 4%)(0.8226) = 7.29%.

Alternative solution: First, calculate the return for each stock using the CAPM
equation [rRF + (rM – rRF)b], and then calculate the weighted average of these
returns. rRF = 4% and (rM – rRF) = (8% – 4%) = 4%.

Stock Investment Beta r = rRF + (rM – rRF)b Weight

A $ 460,000 1.50 10% 0.0954 B 500,000 (0.50) 2 0.1037
C 1,260,000 1.25 9 0.2614
D0.75 2,600,000 7 0.5394 Total1.00
$4,820,000

116 Answers and Solutions Chapter 8: Risk and Rates of Return

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 rp = 10%(0.0954) + 2%(0.1037) + 9%(0.2614) + 7%(0.5394) = 0.0729 = 7.29%.
8-8 In equilibrium:

rL = ˆrL = 10.5%.

rL = rRF + (rM – rRF)b

10.5% = 3.5% + (9.5% – 3.5%)b
10.5% = 3.5% + 6%b
b = 1.1667.

8-9 We know that bR = 2.0, bS = 0.45, rM = 10%, rRF = 5%.

ri = rRF + (rM – rRF)bi = 5% + (10% – 5%)bi.

rR = 5% + 5%(2.0) = 15.00% rS
= 5% + 5%(0.45) = 7.25
7.75%

8-10 An index fund will have a beta of 1.0. If rM is 11.0% (given in the problem) and the risk-free rate is
4.5%, you can calculate the market risk premium (RPM) calculated as rM – rRF as follows:
r = rRF + (RPM)b
11.0% = 4.5% + (RPM)1.0
6.50% = RPM.

Now, you can use the RPM, the rRF, and the two stocks’ betas to calculate their required returns.

Beale:
rB = rRF + (RPM)b
= 4.5% + (6.5%)1.1
= 4.5% + 7.15%
= 11.65%.

Foley:
rF = rRF + (RPM)b
= 4.5% + (6.5%)0.30
= 4.5% + 1.95%
= 6.45%.

The difference in their required returns is:

11.65% – 6.45% = 5.20%.

8-11 rRF = r* + IP = 1.0% + 3.6% = 4.6%.

r = 4.6% + (6.0%)1.5 = 13.60%.

Chapter 8: Risk and Rates of Return Answers and Solutions 117

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8-12 a. ri = rRF + (rM – rRF)bi = 4% + (10% – 4%)1.4 = 12.4%.
b. 1. rRF increases to 5%:
rM increases by 1 percentage point, from 10% to 11%.

ri = rRF + (rM – rRF)bi = 5% + (11% – 5%)1.4 = 13.4%.

2. rRF decreases to 3%: rM decreases

by 1%, from 10% to 9%.

ri = rRF + (rM – rRF)bi = 3% + (9% – 3%)1.4 = 11.4%.

c. 1. rM increases to 12%: ri = rRF + (rM – rRF)bi = 4% +

(12% – 4%)1.4 = 15.2%.

2. rM decreases to 9%: ri = rRF + (rM – rRF)bi = 4%

+ (9% – 4%)1.4 = 11.0%.

8-13 a. Using Stock A (or any stock):

9.55% = rRF + (rM – rRF)bX
9.55% = 5.5% + (rM – rRF)0.9 (rM
– rRF) = 4.5%.
1 1
b. bP = /3(0.9) + /3(1.1) +
1
/3(1.6) bP = 0.3 + 0.3667
+ 0.5333 bP = 1.2.

c. rP = 5.5% + 4.5%(1.2) rP
= 10.9%.

d. Since the returns on the 3

stocks included in Portfolio P
are not perfectly positively
correlated, one would expect
the standard deviation of the
portfolio to be less than 15%.

$142,500
8-14 Old portfolio beta = (b) + $7,500 (1.00)
$150,000 $150,000
1.25 = 0.95b + 0.05
1.20 = 0.95b
1.263158 = b.

New portfolio beta = 0.95(1.263158) + 0.05(0.80) = 1.24.

Alternative solutions:

118 Answers and Solutions Chapter 8: Risk and Rates of Return

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