Deck 12: Investing in Stocks and Bonds

Question 1

What makes for a good investment? Use the approximate yield formula or a financial calculator to rank the following investments according to their expected returns.
a. Buy a stock for $35 a share, hold it for 3 years, and then sell it for $75 a share (the stock pays annual dividends of $2 a share).
b. Buy a security for $15, hold it for 2 years, and then sell it for $55 (current income on this security is zero).
c. Buy a 1-year, 5% note for $925 (assume that the note has a $1,000 par value and that it will be held to maturity).

Answer 1

The yield on investment is the rate at which the present value of all future cash flows from investment will be equal to the current price of investment. This can be computed by the following equation.
…… (1)
a.
Calculate yield on stock by using the equation (1).
Substitute $2 for 'Average Annual income', $75 for 'Future price', $35 for 'Current price', and 3 for 'Number of years'
Therefore, the yield is
.
b.
Calculate yield on security by using the equation (1).
Substitute $0 for 'Average Annual income', $100 for 'Future price', $40 for 'Current price', and 2 for 'Number of years'
Therefore, the yield is
.
c.
Calculate yield on 5% note by using the equation (1).
Substitute $50 for 'Average Annual income' (interest income on note at 5%), $1000 for 'Future price', $925 for 'Current price', and 1 for 'Number of years'
Therefore, the yield is
.
Based on the above calculations the ranking of the investment options is given below.

Question 2

An investor is thinking about buying some shares of Computer Engines, Inc., at $60 a share. She expects the price of the stock to rise to $100 a share over the next 3 years. During that time, she also expects to receive annual dividends of $3 per share. Given that the investor's expectations (about the future price of the stock and the dividends it pays) hold up, what rate of return can she expect to earn on this investment? ( Hint: Use either the approximate yield formula or a financial calculator to solve this problem.)

Answer 2

The yield on investment is the rate at which the present value of all future cash flows from investment will be equal to the current price of investment. In other word, it is the rate at which an investor expects return from the investment. This can be computed by the following equation.
…… (1)
Calculate yield on stock in the following manner.
Substitute $3 for 'Average Annual income', $100 for 'Future price', $60 for 'Current price', and 3 for 'Number of years' in equation (1) ,
Hence, the yield is 20.42%. Thus, it can be concluded that she expects 20.42% return on its investment.

Question 3

The price of Custom Solutions is now $65. The company pays no dividends. Mr. Stephen Conroy expects the price 4 years from now to be $105 a share. Should Mr. Conroy buy stock in Custom Solutions if he desires a 15% rate of return? Explain.

Answer 3

The expected return from investment needs to be computed before the investment decision to be taken. The expected return is the rate at which the present value of all future cash flows from investment will be equal to the current price of investment. In other word, it is the rate at which an investor expects return from the investment. This can be computed by the following equation.
…… (1)
Calculate yield on stock in the following manner.
Substitute $0 for 'Average Annual income', $105 for 'Future price', $65 for 'Current price', and 4 for 'Number of years' in equation (1).
Hence, the yield is 11.76%.
Conclusion
The yield on investment is 11.76% and desired return of Mr. SC is 15% from his investment, which means the expected return on stock is much lower than the desired return. Thus, it can be concluded that he should not invest in the stocks of C Solutions.

Question 4

The Nanotechnology Research Company recently reported after-tax profits of $15.8 million. It has 2.5 million shares of common stock outstanding and pays preferred dividends of $1 million a year. The company's stock currently trades at $60 per share.
a. Compute the stock's earnings per share (EPS).
b. What is the stock's P/E ratio?
c. Determine what the stock's dividend yield would be if it paid $1.75 per share to common stockholders.

Question 5

An investor in the 28% tax bracket is trying to decide which of two bonds to select: one is a 6.5% U.S. Treasury bond selling at par; the other is a municipal bond with a 5.25% coupon, which is also selling at par. Which of these two bonds should the investor select? Why?

Question 6

Describe and differentiate between a bond's (a) current yield and (b) yield to maturity. Why are these yield measures important to the bond investor? Find the yield to maturity of a 20-year, 6%, $1,000 par value bond trading at a price of $750. What's the current yield on this bond?

Question 7

Which of these three bonds offers the highest current yield? Which one has the highest yield to maturity?
a. A 6%, 20-year bond quoted at 97.750
b. A 4%, 15-year bond quoted at 64.625
c. A 5.25%, 18-year bond quoted at 54.000