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Chapter02-AssetClassesandFinancialInvestments

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CHAPTER2:ASSETCLASSESAND

FINANCIALINVESTMENTS

PROBLEMSETS

1. Preferredstockislikelong-termdebtinthatittypicallypromisesafixedpaymenteachyear.Inthisway,itisaperpetuity.Preferredstockisalsolikelong-termdebtinthatitdoesnotgivetheholdervotingrightsinthefirm.

Preferredstockislikeequityinthatthefirmisundernocontractualobligationtomakethepreferredstockdividendpayments.Failuretomakepaymentsdoesnotsetoffcorporatebankruptcy.Withrespecttothepriorityofclaimstotheassetsofthefirmintheeventofcorporatebankruptcy,preferredstockhasahigherprioritythancommonequitybutalowerprioritythanbonds.

2. Moneymarketsecuritiesarecalled“cashequivalents”becauseoftheirgreatliquidity.Thepricesofmoneymarketsecuritiesareverystable,andtheycanbeconvertedtocash(i.e.,sold)onveryshortnoticeandwithverylowtransactioncosts.

3. Thespreadwillwiden.Deteriorationoftheeconomyincreasescreditrisk,thatis,thelikelihoodofdefault.Investorswilldemandagreaterpremiumondebtsecuritiessubjecttodefaultrisk.

4. Onthedaywetriedthisexperiment,36ofthe50stocksmetthiscriterion,leadingustoconcludethatreturnsonstockinvestmentscanbequitevolatile.

5. a. Youwouldhavetopaytheaskedpriceof:

118:31=118.96875%ofpar=$1,189.6875

b. Thecouponrateis11.750%implyingcouponpaymentsof$117.50annuallyor,moreprecisely,$58.75semiannually.

Currentyield=Annualcouponincome/price

=$117.50/$1,189.6875=0.0988=9.88%

6. P=$10,000/1.02=$9,803.92

7. Thetotalbefore-taxincomeis$4.Afterthe70%exclusionforpreferredstockdividends,thetaxableincomeis:0.30?$4=$1.20

Therefore,taxesare:0.30?$1.20=$0.36

After-taxincomeis:$4.00–$0.36=$3.64

Rateofreturnis:$3.64/$40.00=9.10%

8. a. GeneralDynamicsclosedtodayat$74.59,whichwa