Question

Analyse the relationship between bond prices and interest rates during recession. (4m) (250 words)

An investor estimates that next year’s net income for Hilary Pullman Hotel would be RM 8 million. The company has 0.5 million shares outstanding and decided to pay RM 0.5 million to the preferred stockholders from its net income. Listed companies similar to Hilary Pullman Hotel have been recently reported to have an average price/earnings ratio of 4 times. Given the information, calculate the expected price of the stock and evaluate the problems in using Price/earnings ratio method of valuing the shares of a company. (6m)

Answer 1

Part a)
Usually when interest rates rise, the market value of bonds falls. If you have a bond with a coupon of 3% and the cash rate increases from 3% to 4%, the coupon rate on the bond will now seem less attractive to investors so they'll be willing to pay less for it.
During recession, interest rate on bond is typically lowered, so that the investor's required return also falls down as well as price of the bond goes up. For example, coupon rate is 5%, face value & price of bond is 1000. During recession, interest rate falls to 3% then the price of the bond goes up. Price of the bond & interest rate has inverse relationship.

Part b)
Expected earnings available to equity shareholders = Net income - Preference dividend = 8million-0.5million = 7.5million
Earnings per share (EPS) = Expected earnings available to equity shareholders/Number of shares = 7.5million/0.5million = 15 per share
Expected price of the stock = EPS*Earnings ratio = RM 15*4times = RM 60