Question # 5 (12 marks)

(a) (4 marks) Assume that at the beginning of 2016 the expected inflation rate for 2016 is 8 percent, for 2017 it is 6 percent, for 2018 it is 5 percent, and for 2019 it is 5.5 percent.

What is the average interest rate, over the four year period, if the real rate of interest is 2.5%? Do NOT use an arithmetic average. (***Carry all decimal places for interim calculations, round final answers to 4 places.***)

(b) (4 marks) Ayden Inc. issued preferred stock that pays a $5.90 dividend annually each year. This preferred share currently sells for $87 per share.

1) What is the current expected return?

2) Suppose the expected return drops by 2%. What would Ayden Inc. preferred shares sell for now?

(c) (4 marks) A major chemical manufacturer has experienced a market re-evaluation lately due to a number of lawsuits. The firm has a bond issue outstanding with 15 years to maturity and a coupon rate of 8% (paid quarterly).

What is the current value of these bonds, assuming that the level of interest rates has now risen to an effective rate of 16.64 percent?