Question

APM Fund Management is considering the following options for their new investment portfolio:

Option 1 - A non-callable corporate bond that pays coupon rate of 9% annually. The bond will be mature in 20 years. The year-to-maturity (YTM) of the bond is 7.5% and the face value of the bond is $1 000.

Option 2 - An ordinary share which just paid a dividend of $7.50 with a constant dividend growth rate of 5% each year. The current market price of this share is $112.50. Option 3 - A $100 par value preference share which pays a fixed dividend of 13%. The required rate of return of the preference shares in the same group is 12%. Required:

a. How much should APM pay for the corporate bond? If the coupon rate is paid semi-annually, how much is the bond value?

b. Calculate the market required rate of return for the ordinary share. Calculate the share value if the market required rate of return is 10%?

c. Compute the value of the preference share and explain why the preference share is considered a hybrid between an equity and a debt instrument? (1 mark)

Answer 1

a)Calculation of price of bond;

Price of bond is the sum of present value of future coupons and present value of maturity amount.Thus Price of bond is;

=($1000*9%)*PVAF(7.5%,20)+$1000*PVIF(7.5%,20)

=$90*10.1945+$1000*0.2354

=$1152.91

Thus,APM should pay $1152.91 for the corporate bond.

ii)Calculation of price of bond, If the coupon rate is paid semi-annually

no. of period=20*2=40

YTM per period=7.5/2=3.75%

Coupon per period=$90/2=$45

Price of bond=$45*PVAF(3.75%,40)+$1000*PVIF(3.75%,40)

=$45*20.55099+$1000*0.22934

=$1154.13

b)Calculation of market required rate of return for the ordinary share

Required rate of return=[Last dividend(1+growth rate)/Share price]+growth rate

=[$7.50(1+0.05)/$112.50]+0.05

=0.12 or 12%

ii)Calculation of share price if market required rate of return is 10%

Share Price=Last dividend(1+growth rate)/(Required rate of return-growth rate)

=$7.50(1+0.05)/(0.10-0.05)

=$157.50

c)Calculation of value of the preference share

Value of Preference Share=Annual dividend/Required rate of return

=($100*13%)/12%

=$108.33

Since Preferrence shares carry fixed rate of dividend and usually carried a right to be redeemed for cash at maturity,which is features of debt.Thus,preferrence shares are regarded as hybrid between an equity and a debt instrument.