Question

Mr. Lim has $10,000 to invest for a period of 5 years. He has a choice of either the bonds or

stocks of the Oxley Company.

(A) Bond: Oxley’s bond: Face value $1,000, 10% coupon paid annually and 8 years’ life

remaining. The bond can be purchased at $1,100 today.

B) Common Stock: Oxley’s common stock just paid a dividend $0.80. Its dividend will

grow at 4% per year perpetually. The stock can be purchased at $8 today.

(a) Calculate the rate of return per annum over the 5-year period for the investment in bonds

if the required return for the bonds is 7% and coupons can be invested to give a 7%

return.

(b) Compute the rate of return per annum for the investment in stocks over the 5-year

period. The required return for the stock is 12%, while dividends received can be

invested to give a return of 7%.

Answer 1

	(A)	Rate of return on bonds
		Initial Investment =$1100
		Value of Bond at end of 5 years
	Rate	Required Return	7%
	Nper	Number of years left to maturity=8-5=	3
	Pmt	Annual Coupon Payment=1000*10%	$100
	Fv	Amount to be received at maturity	$1,000
	PV	Value of Bond at end of 5 years	$1,079
		(Using PV function of excel)
		Future Value of cash flow at end of year5
		(Cash Flow)*(1+i)^(5-N)
		i=annual return=7%=0.07
		N=Year of Cash Flow	N	A	B=A*(1.07^(5-N)
			Year	Cash Flow	Future Value
		Coupon of Year 1	1	$100	$131
		Coupon of Year 2	2	$100	$123
		Coupon of Year 3	3	$100	$114
		Coupon of Year 4	4	$100	$107
		Coupon of Year 5	5	$100	$100
		Value of Bond at end of 5 years	5	$1,079	$1,079
				SUM	$1,654
		Future Value =FV=	$1,654
		Assume Rate of Return Per year =R
		FV=IC*((1+R)^N)
		FV=Future Value=$1654
		N=Number of years of investment=5
		(1+R)^5=(1654/1100)=	1.5035
		1+R=(1.5035^(1/5))=	1.0850
		Rate of Return Per Year=R=	0.0850
		Rate of Return Per Year	8.50%
	(B)	RETURN FROM INVESTMENT IN STOCKS
		D0= Current Dividend=$0.80
		Dividend in Year N=Dn=D0*((1+g)^N)
		g=Dividend growth Rate=4%=0.04
			Year	Dividend
		D1	1	$0.83	(0.8*1.04)
		D2	2	$0.87
		D3	3	$0.90
		D4	4	$0.94
		D5	5	$0.97
		D6	6	$1.01
		Price of Stock in Year 5=P5=D6/(R-g)
		R=Required Return from stock=12%=0.12
		g=Dividend growth Rate=4%=0.04
		P5=1.01/(0.12-0.04)=	$12.65