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 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 three companies that you have identified to work on. 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 is experiencing a period of rapid growth of 12 percent per year for two years and then slow 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 is a newly listed company and its current market price is RM5. During a press conference in conjunction with its debut in the Bursa Malaysia, the Chairman announced that Beta 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 is an established public company that has been in the bourse for more than two decades. Gamma 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.
A. Calculate the value of all the securities that have been short-listed above.
(20 marks)
B. What are the securities that you would select into your portfolio? Why?
(5 marks)
Please note that no one here will do your work for you. However, we will be happy to read over what YOU THINK and make suggestions and/or corrections.
Please post what you think.
Year 0 1 2 3 4
Units Sold 3,200 4,300 3,900 2,800
Price per unit 780 800 820 840
Total Revenue 2,496,000 3,440,000 3,198,000 2,352,000
Variable cost (15%) 374,400 516,000 468,000 344,400 Variable cost has to be adjusted to make it Rm 120 & 123 for 3rd & 4th year
Fixed Cost 425,000 425,000 425,000 425,000
Depreciation 987,500 987,500 987,500 987,500
Income before tax 709,100 1,511,500 1,317,500 595,100
Tax (38%) 177,275 377,875 329,375 148,775
Net Income 531,825 1,133,625 988,125 446,325
Operating Cash Flow 1,519,325 2,121,125 1,975,625 1,433,825 Net Income + Depreciation
Land
Equipment (4,200,000)
After Tax Salvage 187,500 Since the book value is zero, all amount received will be taxed at 25%
Net Working Capital (125,000) 125,000 Working Capital will be recovered at the end of project
Total Cash Flow (4,200,000) 1,394,325 2,121,125 1,975,625 1,746,325
NPV (13%) 1,135,329
do not copy answer
To calculate the value of the securities, we need to use the appropriate valuation models for each type of security. For bonds, we can use the present value formula, and for stocks, we can use the dividend discount model (DDM). Let's calculate the value of each security:
A. Bonds:
1. Bond ABC:
The coupon payment is half-yearly, so we need to adjust the required rate of return accordingly. The bond will pay 7% of the par value (RM1,000) every year for 20 years. The required rate of return is 9%.
Using the formula for the present value of annuity, we can calculate the value of Bond ABC:
PV = (Coupon Payment / (1 + Required Rate of Return))^n * (1 - (1 / (1 + Required Rate of Return))^n) / (Required Rate of Return) + (Par Value / (1 + Required Rate of Return))^n
PV = (0.07 * RM1,000 / 2) * (1 - (1 / (1 + 0.09))^40) / 0.09 + (RM1,000 / (1 + 0.09))^40
= RM35.27 + RM179.92
= RM215.19
2. Bond PQR:
This is a perpetual bond, which means it has no maturity date. The coupon payment is made quarterly, so we need to adjust the required rate of return accordingly. The bond will pay 7% of the par value (RM1,000) every year.
Using the formula for the present value of perpetuity, we can calculate the value of Bond PQR:
PV = Coupon Payment / Required Rate of Return
PV = (0.07 * RM1,000 / 4) / 0.09
= RM19.44
3. Bond XYZ:
This is a zero-coupon bond, which means it does not pay any coupons. The bond will only provide the principal (face value) at maturity. The required rate of return is 9%.
Using the formula for the present value, we can calculate the value of Bond XYZ:
PV = Par Value / (1 + Required Rate of Return)^n
PV = RM1,000 / (1 + 0.09)^10
= RM400
B. Stocks:
1. Alpha Berhad:
We need to calculate the present value of the expected dividends and the present value of the expected stock price at the end of year 2. The required rate of return is 15%.
Expected Dividends:
Year 1: RM1.50 * (1 + 0.12)
Year 2: RM1.50 * (1 + 0.12)^2
Present Value of Dividends:
PV_dividends = RM1.50 * (1 + 0.12) / (1 + 0.15) + RM1.50 * (1 + 0.12)^2 / (1 + 0.15)^2
Expected Stock Price at the End of Year 2:
PV_stock_price = RM1.50 * (1 + 0.12)^2 / (0.15 - 0.05) / (1 + 0.15)^2
Total PV = PV_dividends + PV_stock_price
2. Beta Industries:
We need to calculate the present value of the expected dividends starting from year 3, and the present value of the expected stock price at year 7. The required rate of return is 15%.
Expected Dividends from Year 3 to 6:
RM0.30 * (1 + 0.05)^i for i = 0 to 3
Present Value of Dividends:
PV_dividends = [RM0.30 / (1 + 0.15)^3] + [RM0.30 * (1 + 0.05) / (1 + 0.15)^4] + [RM0.30 * (1 + 0.05)^2 / (1 + 0.15)^5] + [RM0.30 * (1 + 0.05)^3 / (1 + 0.15)^6]
Expected Stock Price at Year 7:
PV_stock_price = RM0.30 * (1 + 0.05)^3 / (0.15 - 0.05) / (1 + 0.15)^6
Total PV = PV_dividends + PV_stock_price
3. Gamma Corporation:
The dividend is fixed at RM2 and there is no growth. The required rate of return is 15%.
Present Value of Dividends:
PV_dividends = RM2 / (1 + 0.15) + RM2 / (1 + 0.15)^2 + RM2 / (1 + 0.15)^3 + ...
Total PV = PV_dividends
B. To select securities for the portfolio, we need to compare the calculated values of the securities and select those with higher values. Based on the calculations, we can choose the securities with higher present values.