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:
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)
bonds with high coupon payments or coupon rate with longer time to matuity will be preferred
c)
Expected return = risk free rate + beta * market risk premium
= 0.05 + 1.5 * (0.15-0.05)
= 0.2 or 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
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