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 need to determine the present value of the cash flows expected to be received from each security.
1. Bonds:
a. Bond ABC: It pays a half-yearly coupon at an annual rate of 7 percent and matures in 20 years. To calculate its value, we can use the present value of a bond formula:
Value_ABC = (Coupon_ABC / (1 + (Required_Rate / 2))^n) + (Face_Value_ABC / (1 + (Required_Rate / 2))^n)
Where:
- Coupon_ABC is the coupon payment per period (RM1,000 x 7% / 2)
- Required_Rate is the rate of return required (9%)
- n is the number of periods until maturity (20 years x 2)
b. Bond PQR: It is a perpetual bond with a face value of RM1,000 and pays interest to investors at the end of every quarter. The present value of a perpetual bond can be calculated as:
Value_PQR = Coupon_PQR / Required_Rate
Where:
- Coupon_PQR is the coupon payment per period (RM1,000 x 7% / 4)
c. Bond XYZ: It is a zero-coupon bond with a face value of RM1,000 and matures in 10 years. The present value of a zero-coupon bond can be calculated as:
Value_XYZ = Face_Value_XYZ / (1 + Required_Rate)^n
Where:
- Face_Value_XYZ is the face value of the bond (RM1,000)
- n is the number of years until maturity (10)
2. Common Stocks:
a. Alpha Berhad: To calculate the value of a stock with changing growth rates, we can use the dividend discount model (DDM) formula:
Value_Alpha = (D0 x (1 + g1)) / (Required_Rate - g1) + (D1 x (1 + g2)) / (Required_Rate - g2) / (1 + Required_Rate)
Where:
- D0 is the most recent annual dividend paid (RM1.50)
- g1 is the growth rate for the first two years (12%)
- g2 is the constant growth rate after two years (5%)
b. Beta Industries Berhad: We can use the constant growth DDM formula to calculate the value:
Value_Beta = D3 / (Required_Rate - g) / (1 + Required_Rate)^3
Where:
- D3 is the expected dividend three years from now (RM0.30)
- g is the constant growth rate after four years (5%)
c. Gamma Corporation Berhad: The value of a stock with constant dividends can be calculated using the constant dividend DDM formula:
Value_Gamma = D / Required_Rate
Where:
- D is the fixed dividend paid (RM2)
Now that we have the formulas, let's calculate the values for each security and compare them to make a recommendation:
1. Calculate the value of all the securities:
- Value_ABC = (Coupon_ABC / (1 + (Required_Rate / 2))^n) + (Face_Value_ABC / (1 + (Required_Rate / 2))^n)
- Value_PQR = Coupon_PQR / Required_Rate
- Value_XYZ = Face_Value_XYZ / (1 + Required_Rate)^n
- Value_Alpha = (D0 x (1 + g1)) / (Required_Rate - g1) + (D1 x (1 + g2)) / (Required_Rate - g2) / (1 + Required_Rate)
- Value_Beta = D3 / (Required_Rate - g) / (1 + Required_Rate)^3
- Value_Gamma = D / Required_Rate
2. Selecting securities for the portfolio:
To choose the securities for the portfolio, we need to compare the calculated values and select the ones with higher values. The higher the value, the more undervalued the security is relative to its price.
Consider the calculated values for each security and compare them. Select the securities with the highest calculated values, as they are expected to provide a higher return relative to their prices.
Remember to consider diversification when constructing a portfolio. It is generally recommended to have a mix of different asset classes (stocks and bonds) to diversify risk and potentially increase returns.