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

(a)

As per CAPM

k_e = R_f + Risk premium * beta

R_f = 2%

Risk Premium = 10%

Beta = 1.2

k_e = 0.02 + 0.10 * 1.2

= 0.02 + 0.12

= 0.14 Or 14%

year	Earnings	Dividend payout @ 30%	PVIF @ 14%	Present Value
1	2.40	0.72	0.8772	0.63
2	2.88	0.86	0.7695	0.66
3	3.46	1.04	0.6750	0.70
4	4.15	1.24	0.5921	0.74
5	4.98	1.49	0.5194	0.78
				3.51

After 5 yearsearnings become constant, so according to perpetuity..

P₅ =

P₅ = Price at the end of year 5

D₆ = Dividend at year 6 = D₅ = 1.49 as earnings constant after 5 years

P₅ =

= $10.64

Price of the share = Present value of all dividends till 5years + Present Value of P₅

= 3.51 + 10.64 * 0.5194 (PVIF 14%,5)

= 3.51 + 5.53

= $9.04

(b) Current Value of Share = $9.04

Current price of share in the market = $10

Hence, the stock is Overvalued.

   As investor go for short position on such shares. Overvalued share likely to experience a price decline and return to alevel. It is better to sell out his holdings and make profit before price falls.

As per efficient market hypothesis it is a weak form of efficiency.

Other two forms of market efficiency are:

1. Semi strong Efficiency
2. Strong Efficiency

1. Semi strong form efficiency assumes that current stock price adjust rapidly to release of new public information , Investor cannot utilize fundamental analysis to gain higher returns.

2. Strong Efficiency states all information which is public or not, is completely accounted for current stock prices and no type information give to investor as advantage on market.

(c)

ABC company plans to issue a 7-year bond in the near future to finance expansion and expects interest rates to fall in 3 years’ time. It can go for either Coupon bond or Zero Coupon Bond.

If interest rate of bond declines, bond price will rise and higher the yield to maturity.

Zero Coupon Bond is a bond on which interest component is never paid . It issued at discount price and maturity at par value.

Coupon Bond is a simple coupon bond in this interest component paid over the period of bond at agreed coupon rate. at the time of maturity principal amount also repaid.

Price of Zero Coupon Bond =

r = Yield to maturity rate

t = time to maturity

Price of Coupon Bond = Present value of all coupons till maturity discounted at Yield to maturity rate + Present value of maturity amount

=

C = Coupon amount

YTM = Yield to maturity

P = Maturity Value

t = time to maturity.