Question

Company ABC has just announced earnings of $2 per share. Based on the last five years, earnings have grown at a rate of 20% per annum and the company expects this to continue for the next five years, after which it expects earnings to remain constant forever. The company has a policy of paying out 30% of its earnings as dividends. ABC stock has a beta of 1.2. The yield to maturity on 10-year government bonds is 2% and market risk premium is 10%.

(a) Calculate the current value per share.

(b) If the stock is currently trading in the market at $10 per share, comment on whether any profits can be made. What form of market efficiency prevails if this occurs? Examine the other two (2) forms of market efficiency and what the observation on the stock price here implies in terms of market efficiency.

(c) The company plans to issue a 7-year bond in the near future to finance expansion into neighbouring countries. It expects interest rates to fall in 3 years’ time. State and describe two (2) possible types of bonds the company could issue. Analyse how the company can determine the pricing for its bond issue?

Answer 1

Working: -

2. In case the stock price average in the market is $10, then the stock would be stated as overvalued. Since $9.05 would be the current value of the share. He should sell the share if the investor is holding it. There is a possibility that stock which is overvalued suffers a steady fall in its stock price and return to a certain level that would reflect better position in terms of financials.

The investor then take a decision to sell its holdings in the stock to attribute amount of profit until the price falls. As per the efficiency of market it would be categorized under weak type of efficiency.

The two market efficiency forms are: -

Semi strong and strong efficiency: - The form pf semi-strong would claim that the knowledge among the public constitutes the current price of the stock, investors use various types of analysis like the technology and fundamental to attribute the utmost benefits among the investors.

The strong efficiency would further note that full information should be accounted to the investors in relation to its current price of stock both in public and non-public.

3. If ABC is planning to issue the bond for a period of seven years and it would expect that interest rate would decline in the future, then it is recommended to go for coupon bond or the zero coupon bond. If interest rates fall, the yield for bond will increase and the yield to maturity will be elevated with the decrease in the rate of interest.