Review Problems: Exam 1 (Investment Basics – Stock and Bonds)

Review Problems

A 1. The Transport corporation just made $3,000,000 in income for it=s first year of operations. When the corporation started up, it issued 25,000($1,000 par value) 5 year 6% annual coupon bonds, 150,000 shares of preferred stock at $100 par value that pay an 8% dividend, and 5 million shares of common stock were issued at $4 per share. The Transport corporation wants to pay a $.10 per share common stock dividend and the only cash available for all payments is the $3,000,000 in income they earned this year.

A. In order of priority, who must be paid first?

B. How much will the total payment to bondholders be this year?

C. How much will the total payment to preferred stock holders be?

D. How much will the total payment to common stockholders be?

A 2. Cisco is selling at $45 a share. You would like to buy 200 shares for $42 a share using 60% margin. Cisco pays no dividends and the interest rate on a margin loan is 6%.

A. What type of order would you place to buy Cisco at $42.

B. Assuming your order gets executed for $42, how much money would you have to put up?

C. What type of order would place after buying Cisco for $42 to sell it at $35?

D. If Cisco does fall to $35 after one year and your order is executed, what was your return on equity?

A 3. Barnes and Noble is selling for $55 a share. You think it is going to fall to $30 a share.

A. What would you do to profit from your expectations and how much would you make?

B. After executing your action in A, what type of order would you place to minimize your loss to approximately $7 a share?

C. Assuming you used 50% initial margin, what would be the margin call price with a maintenance margin of 30%?

A 4. You have decided to create a price weighted and value weighted index using the two largest stocks in a five stock market. These two stocks make up 65% of the value of the market. The number of shares and prices for all five stocks over the last three years are given below.

|Stock |No. of Shares |Year 1 |Year 2 |Year 3 |

|A |2,000 |$40 |$48 | $49 |

|B |1,500 |$20 |$22 |$25 |

|C |800 |$30 |$28 |$33 |

|D |400 |$17 |$19 |$23 |

|E |300 |$25 |$27 |$26 |

a. Using just stocks A and B, what is the price-weighted index for the three years? What are the percentage changes?

b. Using just stocks A and B and starting your index at 10, what is the value weighted index for the three years? What are the percentage changes.

c. Now find the percentage changes for price and value weighted indexes using all five stocks.

d. How well did your two stock index indicate the actual performance of the entire market?

Answers to Review Problems

1.

A. Bondholders must be paid first. If the corporation does not have the assets to pay it=s bondholders, the bondholders can take control of the corporation, force it into bankruptcy, and liquidate assets to pay the bonds off. This is only done as a last resort but sometimes does occur. Preferred stockholders are next in line but they are paid their dividends only if cash is available. Preferred shareholders cannot force the corporation into bankruptcy if they are not paid, but the common shareholders cannot be paid until after the preferred dividends are paid.

B. With a 6% coupon on $25 million of debt, the total coupon payments will be .06 * $25 million = $1.5 million.

C. Total preferred dividends are .08 * $15 million = $1.2 million

D. Since the company only had $3 million to make payments and $2.7 million had to be paid out to bondholders and preferred stockholders, only $300,000 is left for distribution to the common stockholders. With 5