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

1.

As per CAPM	Re=Rf+B*(Rm-Rf)	Re=2%+ 10%*1.2	Re= 14%
Rf	2%
Risk premium	10%
Beta	1.20
Price of the share = present value of dividend for 5 years+ present value of perpetuity
=3.51+(10.6642*0.5194)
9.05	$9.05
Year	EPS Growing @ 20%	Dividend pay out @ 30%	PVF@ 14%	PV of dividend per share
1	2.400	0.720	0.8772	0.63
2	2.880	0.864	0.7695	0.66
3	3.456	1.037	0.6750	0.70
4	4.147	1.244	0.5921	0.74
5	4.977	1.493	0.5194	0.78
				3.51
	after 5 year earnings constant, hence as per perpetuity p0= D1/ke-g	=1.493/.14-0
					10.66429

2

If the current trading price of stock in the market is $ 10 then the stock is overvalued as the current value per share is $9.05 . As an investor, he should go for a short position on such stocks. An overvalued stock is likely to experience a price decline and return to a level which better reflects its financial status. Hence the investor should sell out his holding and make a profit before the price dips. It is a weak form of efficiency as per efficient market hypothesis.
The other 2 form of market efficiency are
Semi Strong and strong efficiency: The semi-strong form submits that because public information is part of a stock's current price, investors cannot utilize either technical or fundamental analysis, though information not available to the public can help investors.The strong form version states that all information, public and not public, is completely accounted for in current stock prices.

3. if ABC company is planning to issue bonds for 7 years duration and expects the interest rate will fall in future then it can go for a coupon bond or a zero coupon bond. if interest rates decline, bond prices will rise and as lower the interest rate high the yield to maturity.

Zero coupon Bond: ZCBs are issued at discount and at the maturity paid at par value. There is no payment of interest component in ZCB.
Regular coupon bond: these debt instruments pay, interest over the life of the bond and also repay the principal at maturity.

Pricing of Zero coupon Bond = Maturity value after 7 year /(1+ interest yield dividend )
Pricing of a coupon Bond= present value of all future cash flows included the principal repayment that is to be paid by the company after 7 year