Question

Cassey Computer Ltd. has an outstanding issue of bond with a par value of $1,000, paying 8 percent coupon rate semi‑annually. And, the company just paid a dividend of $2.70 per share. The dividends are expected to grow at 5.0 percent for next 2 years. i.e. year 1 and 2, and after year 2, dividends are estimated to grow at 4 percent thereafter indefinitely. Based on market information, government bond’s yield for 10-year maturity is 5 percent, market expected return is 15 percent, and beta of Cassey’s stock is 1.5. Assume no market friction and taxes.

Required:

1. The bond of Cassey Computer Ltd. was issued 25 years ago and has 5 years to maturity. What is the value of the bond assuming 10 percent rate of current interest rate?

2. If interest rate is expected to decrease, what characteristics and types of bonds would have better performance?

3. Assume that the forecasted dividends and the required return are the same one year from now, as those forecasted today. What is the expected intrinsic value of the stock one year from now, just after the dividend has been paid in year one?

Answer 1

a)

price of coupon = Coupon payment per period * [1-(1+i)^-n]/i + par value/(1+i)^n

i = interest rate per period

n = number of periods

Price = (80/2) * [1-(1+0.1/2)^-10]/(0.1/2) + 1000/(1+0.1/2)^10

= 922.78

b)

bond with high coupon payments or coupon rate with longer time to yield to maturity are preferred as they will fetch more value

c)

Expected return = risk free rate + beta * market risk premium

= 0.05 + 1.5 * (0.15-0.05)

= 20%

value of stock = Present value of dividends + Horizontal value

Horizontal value = dividend next year/(Required return - growth rate)

= 2.7 *1.05^2 * 1.04/(0.2-0.04)

= 19.348875

value of stock = 2.7*1.05^2/1.2 + 19.348875/1.2

= 18.61