Your company is considering diversifying its investment in financial securities into both stocks and bonds. You are asked to evaluate the following alternatives and make your recommendations as to the securities that your company should select.
Bonds:
There are several bonds traded in the market. Assuming that they are all in the same risk class, and you believed that a 9 percent rate of return should be required. The following bonds are those that you feel worth considering:
• Bond ABC, selling in the market at RM700, has a RM1,000 par value, pays a half-yearly coupon at annual rate of 7 percent, and is scheduled to mature in 20 years.
• Bond PQR is a perpetual bond with a face value of RM1000 and a 7 percent coupon rate. The bond, which is selling at RM500 now, pays interest to its investors at the end of every quarter.
• Bond XYZ is a zero-coupon bond with a face value of RM1,000. Currently priced at RM400, this bond will mature in 10 years.
Common stocks:
You are considering the common shares of the three companies that you have identified to work with. The market's required rate of return on common equity is 15 percent. More information on each share is as below:
• Alpha Berhad is selling at RM15 per share. You expect the company will be experiencing a period of rapid growth of 12 percent per year for the next two years and then slow down to a constant growth of 5 percent per year due to competitors entering the market. The most recent annual dividend paid by Alpha was RM1.50.
• Beta Industries Berhad is a newly listed company and its current market price is RM5 per share. During a press conference in conjunction with its debut on the Bursa Malaysia, the Chairman announced that Beta Industries will only pay its first dividend three years from now to enable the company to cope with the capital requirements to support growth. This expected dividend of RM0.30 per share will remain constant for four years, and after that will grow at a rate of 5 percent forever.
• Gamma Corporation Berhad is an established public company that has been in the bourse for more than two decades. Gamma Corporation has been paying fixed dividends of RM2 to their shareholders for a long time and it seems that there is no indication that they are going to raise it. The current price of Gamma common share is RM10 per share.
1. Calculate the value of all the securities that have been shortlisted above.
2. What are the securities that you would select into your portfolio? Why?
To calculate the value of the securities, we will use the present value formula, which is the sum of the present value of coupon payments and the present value of the face value at maturity.
1. Calculating the value of the bonds:
a) Bond ABC:
The annual coupon payment is 7% of RM1,000 = RM70.
The bond matures in 20 years. Assuming a 9% required rate of return, we use the present value formula:
PV of coupons = RM70 * (1 - [1 / (1 + 9%)^40]) / 9% = RM738.69
PV of face value = RM1,000 / (1 + 9%)^40 = RM164.29
Value of Bond ABC = PV of coupons + PV of face value = RM738.69 + RM164.29 = RM902.98
b) Bond PQR:
The quarterly coupon payment is 7% of RM1,000 = RM70.
The bond is perpetual, so we calculate the present value of the interest payments indefinitely:
PV of coupon payments = RM70 * (1 / 0.15) = RM466.67
Value of Bond PQR = PV of coupon payments = RM466.67
c) Bond XYZ:
The bond has no coupon payments and only pays the face value at maturity.
The bond matures in 10 years. Assuming a 9% required rate of return, we use the present value formula:
Value of Bond XYZ = RM1,000 / (1 + 9%)^10 = RM422.35
2. Selecting securities for the portfolio:
Based on the value calculations, the securities to select for the portfolio would be:
- Bond ABC with a value of RM902.98
- Bond PQR with a value of RM466.67
- Bond XYZ with a value of RM422.35
The reason for selecting these securities is that they all have values greater than their market prices, indicating that they are undervalued. This means the potential for higher returns is higher compared to their current market prices.
Additionally, the bonds provide a fixed income stream with different terms and coupon frequencies, which can help diversify the portfolio. By investing in both stocks and bonds, the portfolio can potentially achieve a balance between income stability (bonds) and potential capital appreciation (stocks).
To calculate the value of the securities and determine which ones to select for your portfolio, you need to evaluate each option based on their expected rate of return and compare it to the required rate of return.
1. Calculating the value of the bonds:
a) Bond ABC:
The annual coupon payment is 7% of the par value, which is RM1,000.
The bond has a 20-year maturity, paying coupon semi-annually.
To calculate the present value of the bond, we can use the present value of an annuity formula.
PV = Coupon Payment * [1 - (1 + r)^(-n)] / r + Par Value / (1 + r)^n
Where r is the required rate of return and n is the number of periods.
PV = (RM1,000 * 0.07 / 2) * [1 - (1 + 0.09)^(-40)] / 0.09 + RM1,000 / (1 + 0.09)^40
b) Bond PQR:
The bond is perpetual with a face value of RM1,000 and a 7% coupon rate.
To calculate the present value of the perpetual bond, we use the Gordon Growth Model.
PV = Coupon Payment / Required Rate of Return
PV = RM1,000 * 0.07 / 0.09
c) Bond XYZ:
The bond is a zero-coupon bond with a face value of RM1,000 and 10 years to maturity.
To calculate the present value of the zero-coupon bond, we use the present value formula.
PV = Face Value / (1 + r)^n
PV = RM1,000 / (1 + 0.09)^10
2. Calculating the value of the stocks:
a) Alpha Berhad:
The stock is expected to have rapid growth of 12% for the next two years and then slow down to a constant growth rate of 5%.
To calculate the present value of the stock, we can use the dividend discount model.
PV = D1 / (r - g) + D2 / (r - g)^2 + ... + DT / (r - g)^T
Where D is the expected dividend at each time period, r is the required rate of return, g is the constant growth rate, and T is the time period.
PV = RM1.50 / (0.15 - 0.05) + RM1.50 * (1.05) / (0.15 - 0.05)^2
b) Beta Industries Berhad:
The stock will pay its first dividend three years from now and then has a constant dividend growth rate of 5%.
To calculate the present value of the stock, we can use the dividend discount model.
PV = D1 / (r - g) + D2 / (r - g)^2 + ... + DT / (r - g)^T
PV = RM0.30 / (0.15 - 0.05)^3 + RM0.30 * (1.05) / (0.15 - 0.05)^5 + ...
c) Gamma Corporation Berhad:
The stock has a fixed dividend of RM2.
To calculate the present value of the stock, we can use the perpetuity formula.
PV = Dividend / Required Rate of Return
PV = RM2 / 0.15
3. Compare the calculated present values of all the securities to determine their attractiveness relative to each other and the required rate of return. Select the securities that have a higher present value than their current market price.
In summary, calculate the present value of each bond and stock using the appropriate present value formulas, compare them to the required rate of return, and select the securities with higher present values for your portfolio.