1.Robert Campbell and Carol Morris are senior vice-presidents of the Mutual of Chicago Insurance Company. They are co-directors of the company's pension fund management division, with Campbell having responsibility for fixed income securities (primarily bonds) and Morris being responsible for equity investments. A major new client, the California League of Cities, has requested that Mutual of Chicago present an investment seminar to the mayors of the represented cities. Campbell and Morris, who will make the actual presentation, have asked you to help them by answering the following questions.

a.What is the value of a 1-year, $1,000 par value bond with a 8% annual coupon if its required rate of return is 12%? What is the value of a similar 10-year bond?

b.What would be the valueof the bond described in part (a) if, just after it had been issued, the expected inflation rate rose by three percentage points, causing investors to require a 15% return? Is the security now a discount bond or a premium bond?

c.What would happen to the bond's value if inflation fell, and r_ddeclined to 8%? Would it now be a premium bond or a discount bond?

d.What is the yield to maturity on a 10-year, 8% annual coupon, $1,000 par value bond that sells for $880.00? That sells for $1,130.50? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between r_dand the bond's coupon rate?What would happen to the value of the 10-year bond over time if the required rate of return remained at (i) 12% or (ii) remained at 8%?

2.Robert Campbell and Carol Morris are senior vice-presidents of the Mutual ofChicago Insurance Company. They are co-directors of the company's pension fund management division. A major new client has requested that Mutual of Chicago present an investment seminar to illustrate the stock valuation process. As a result, Campbell and Morris have asked you to analyze the Bon Temps Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. You are to answer the following questions.

a.What happens if the growth is constant, and g > r_s? Will many stocks have g > r_s?

b.Assume that Bon Temps' earnings and dividends are expected to decline by a constant 4% per yearthat is, g = -4%. Why might someone be willing to buy such a stock, and at what price should it sell? What would be the dividend yield and capital gains yield in each year?

c. Assume that Bon Temps is expected to experience supernormal growth of 25% for the next 4 years, then to return to its long-run constant growth rate of 8%. What is the stock's value under these conditions? What are its expected dividend yield and its capital gains yield in Year 1? In Year 6?