Part 2
The return will be computed using the yield to maturity formula. YTM captures all the relevant information in the valuation.
1)
Corporate bond
YTM = C+(F-P)/n(F+P/2
C is the coupon payment = 10.125% *1000 = 101.25
F is the face value = 1,000
P is the price = 879.625
N is the periods to maturity = 25
YTM = 101.25+(1,000-879.625)/25(1000+879.625)/2 = 11.6%
Government Bond
YTM = C+(F-P)/n(F+P/2
C is the coupon payment = 6.825% *1000 = 68.25
F is the face value = 1,000
P is the price = 975.42
N is the periods to maturity = 25
YTM = 68.25+(1,000-975.42)/25(1000+975.42)/2 = 7.01%
I would select the corporate bond. It has a higher return than the government bond. The corporate bond has a yield of 11.6 percent while the government bond has a yield of 7.01 percent. Secondly, the yield of the corporate bond is greater than the expected yield of the investment. However, that of the government bond is below the threshold.
Question 2
Dividend = 10%*50 = 5
The rate of return = Dividend/Market Price
The rate of return = 5/42 = 11.9%
I will not be willing to purchase the preferred stock. The return of the investment is 11.9 percent which is slightly less than the required rate of return for this type of investment. Preferred stock are also less liquid and do not have a maturity date.
Question 3
Value of Stock = DPS/ (Discount rate – Dividend growth rate)
Growth rate = Average retention rate * Return on Invested Capital
Average retention rate = 1- Pay-out ratio
Pay-out ratio = Dividend per share/ Earnings per share = 0.65/1.89 = 34.39%
Return on Invested Capital = Net Income/ Capital Employed = 1,417,500/6,000,000 = 23.625%
Growth = 0.3439*0.23625 = 8.12%
Value of stock = 0.65/ (0.1583-0.0812) = 8.43
Free Cash flow method
Firm value = Free cash flows Next year / (WACC - g) = 109,237(1+0.0812)/ (0.1583-0.0812) = 1,531,868.28
Value per share = 1,531,868.28/750,000 = 2.04
The valuation of the shares using both methods yields a stock value that is way below the market price. The valuation under present value method is 8.43 while the valuation under the free cash flow method is 2.04. Therefore, the shares are grossly overpriced. I will not invest in the shares. The return will not only be below the required rate of return but also I would obtain better valued investments in the capital market with better returns and a valuation that is closer to the true value. Investment in stock also has a higher risk compared to other alternative investments.
Question 4
The stock will be valued by calculating the present value under each of the three scenarios separately. In the last period the amount will be determined using the constant growth model.
Under the alternative scenario, I would be interested in purchasing the shares. This is because the shares are trading at a great discount. The market price is below 5o the true value of the stock is 821.29. Therefore, for each stock I would receive a discount of more than 700.
References
Gibson, C. (2012). Financial Reporting and Analysis: Using Financial Accounting Information. London: Cengage Learning.
Khan, W. (2004). Financial Management: Text, Problems And Cases. New York: Tata McGraw-Hill Education.
Shim, J., & Siegel, J. (2008). Financial Management (New ed.). New York: Barron's Educational Series.
Weetman, P. (2006). Financial Accounting: An Introduction. London: Pearson Education.
