Finance Revision – Interest rates + Capital budgeting Finance – Revision Exercise 2 (i) – Interest rates, bonds, forward rates & shares 1. How would you write the following expression: the two year forward rate starting in three years time? 2. If the one, two, three, four year spot rates are 5%, 6%, 7%, 8% respectively, what is the one year forward rate starting in two years time? 3. A bond is priced at £96.45 in the market. It’s coupon rate is 4%, the bond has four years to redemption. What is the yield to maturity? 4. If the one, two, three, and four year spot rates are 4%, 4.5%, 5% and 5.25%, what will be the price of a four year bond with a 7% coupon? 5. There are three zero coupon government bonds, maturing in one, two and three years time. The prices are £93.50, £86.90, and £80.10 respectively. What are the spot rates that can be derived from these prices, and if there is a three year 9% coupon bond available in the market what will be its price? Given that price, what is the yield to maturity? 6. A company has dividends of 5.8p, 6p, 6.3p, 6.7p, 7.1p, 7.7p, 8.5p in 2004 through to 2010 respectively. If the cost of equity for the company is 14%, what is the share price if you base the growth of dividends on (i) the entire period, (ii) the last two years (2008 – 2010)? 7. How useful is the price-earnings ratio as a measure of value? List the advantages and disadvantages of its use. 8. What are the problems with the dividend growth model as a means of valuing shares? 9. What features can a bond have that may help overcome the agency problems that bondholders have with managers and shareholders? 10. If you have a 4 year bond with a 7% coupon, and the term structure of interest rates for the next four years is 4%, 5%, 6% and 6.5% respectively, what is the price of the bond and what is its duration? What does duration tell us (in general)? src.doc 1- Finance Revision – Interest rates + Capital budgeting Finance – Revision Exercise 2 (ii) – Capital budgeting 1

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