PART 2: VAlUATION, RISK AND RETURN
PROBlEMS
UNDERSTANDING RETURNS
P6-1 You purchase 1,000 shares of Spears Grinders for $50 per share. A year later, the shares pay a
dividend of $1.20 each and sell for $59.
a Calculate your total dollar return.
b Calculate your total percentage return.
c Do the answers to parts (a) and (b) depend on whether you sell or continue to hold the shares
after one year?
P6-2 A financial adviser claims that a particular share earned a total return of 10% last year. During the
year, the share price rose from $30 to $32.50. What dividend did the share pay?
P6-3 D.S. Trucking Company shares pay a $1.50 dividend every year without fail. A year ago, the shares sold
for $25 each, and their total return during the past year was 20%. What do the shares sell for today?
P6-4 Nano-Motors has shares outstanding, which sell for $10 per share. Macro-Motors shares cost $50
each. Neither company pays dividends at present.
a An investor buys 100 shares of Nano-Motors. A year later, each share sells for $15. Calculate the
total return in dollar terms and in percentage terms.
b Another investor buys 100 shares of Macro-Motors. A year later, the share price has risen to $56.
Calculate the total return in dollar terms and in percentage terms.
c Why is it difficult to say which investor had a better year?
P6-5 David Rawlings pays $1,000 to buy a five-year Treasury bond that pays a 5% coupon rate. (For simplicity,
assume annual coupon payments.) One year later, the market’s required return on this bond has
increased from 5% to 7%. What is Rawlings’ total return (in dollar and percentage terms) on the bond?
P6-6 G Welch purchases a corporate bond that was originally issued for $1,000 several years ago. The bond
has four years remaining until it matures, the market price now is $1,054.45, and the yield to maturity
(YTM) is 4%. The bond pays an annual coupon of $55, with the next payment due in one year.
a What is the bond’s coupon rate? What is its coupon yield?
b Suppose Welch holds this bond for one year and the YTM does not change. What is the total
percentage return on the bond? Show that on a percentage basis, the total return is the sum of
the interest and capital gain/loss components.
c If the YTM decreases during the first year from 4% to 3.5%, what is the total percentage return that year?
P6-7 In this advanced problem, let’s look at the behaviour of ordinary Treasury bonds and inflation indexed
bonds, or TIPS. We will simplify by assuming annual rather than semiannual interest payments. Suppose
that over the next five years investors expect 3% inflation each year. The Treasury issues a five-year ordinary
bond that pays $55 interest each year. The US Treasury issues a five-year TIPS that pays a coupon rate of
2%. With TIPS, the coupon payment is determined by multiplying the coupon rate times the inflation-
adjusted principal value. Like ordinary bonds, TIPS begin with a par value or principal value of $1,000.
However, that principal increases over time as inflation occurs. Assuming that inflation is in fact equal to 3%
in each of the next five years, then the cash flows associated with each bond would look like this:Year T-bond pays TIPS pays Inflation-adjusted
principal (TIPS)Coupon payment
calculation
0 (cost) –1,000.00 –1,000.00 –1,000.00 NA
1 55.00 20.60 1,030.00 1,000.00(1.03) × 2%
2 55.00 21.22 1,060.90 1,030.00(1.03) × 2%
3 55.00 21.85 1,092.73 1,060.90(1.03) × 2%
4 55.00 22.51 1,125.51 1,092.73(1.03) × 2%
5 1,055.00 1,182.46 1,159.27 1,125.51(1.03) × 2%See the problem and
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