Question

Apollo Inc paid a dividend last year of $1.50. Dividends are expected to grow at a rate of 17% this year, 15% next year, 10% the following year and 5% thereafter. The required rate of return is 15%. Apollo is considering investing in a 15-year bond with a 5.5% coupon, interest paid semiannually. The current market interest rate is 6.5%, and the bond is priced at $940.

1) What is the price of the stock for Apollo Inc 1 years from now?
2) What is the price of the stock for Apollo Inc 4 years from now?
3) Suppose the bond described above pays interest annually rather than semiannual. Should Apollo purchase the bond? What is the maximum price you should pay for the bond?

Answer 1

Answer 1.

Last-year Dividend, D0 = $1.50

D1 = $1.5000 * 1.17 = $1.7550
D2 = $1.7550 * 1.15 = $2.0183
D3 = $2.0183 * 1.10 = $2.2201
D4 = $2.2201 * 1.05 = $2.3311
D5 = $2.3311 * 1.05 = $2.4477

Constant growth rate, g = 5%
Required Return, r = 15%

P4 = D5 / (r - g)
P4 = $2.4477 / (0.15 - 0.05)
P4 = $24.48

Answer 2.

P1 = $2.0183/1.15 + $2.2201/1.15^2 + $2.3311/1.15^3 + $24.48/1.15^3
P1 = $21.06

Answer 3.

Face Value = $1,000
Annual Coupon = 5.5%*$1,000 = $55
Period = 15 years
Market Interest Rate = 6.5%

Bond Price = $55 * PVIFA(6.5%, 15) + $1,000 * PVIF(6.5%, 15)
Bond Price = $55 * (1 - (1/1.065)^15) / 0.065 + $1,000 / 1.065^15
Bond Price = $905.97

Market price per bond is $940 which is higher than its expected price. So, Apollo should not buy this bond. Maximum price Apollo should pay for this bond is $905.97