Question

Junior just received his annual bonus and is looking to invest it in one of two potential investments. Junior is considering a 10-year 9% coupon bond issued by HomeCo that is currently selling for $1,024.51. His other option is to buy stock in Residential Inc. Residential just issued a $1.2 dividend and expects to grow at 4%. Residential’s current stock price is $42.30. If both investments are fairly priced and Junior intends to hold the investment indefinitely, which offers a higher return?

The stock, 6.84% > 4.31%

The bond, 9.00% > 2.95%

The bond, 8.63% > 6.95%

The stock, 4.31% > 4.00%

Answer 1

Calculating Return of bond

No of years to maturity = 10 years , Coupon rate = 9% , Par value = $1000, Current selling price = $1024.51

Coupon payment = Coupon rate x par value = 9% x 1000 = 90

We find the return earned on bond, by finding yield to maturity of bond

Yield to maturity can be found out using RATE function in excel

Formula to be used in excel: =RATE(nper,-pmt,pv,-fv)

Using RATE function in excel, we get yield to maturity of bond = 8.63%

Hence realized return of bond = 8.63%

Calculating return of stock

Growth rate of dividends = g = 4%, Current stock price = P = $42.30, Current dividend = D0 = $1.2

Expected dividend = D1 = D0 (1+g) = 1.2(1+4%) = 1.2 x 1.04 = 1.248

Since the stock is fairly priced, so we can use constant growth rate model to return of stock

Now, according to constant growth rate model

Return on stock = (D1 / P0)+ g = (1.248 / 42.30) + 4% = 2.95% + 4% = 6.95% = 6.95%

So Return on stock = 6.95%

As can been return of bond is higher than return on stock

Answer : The bond, 8.63% > 6.95%