Question

Please show works

1.The H&H Computer Company has an outstanding issue of bond with a par value of $1,000, paying 12 percent coupon rate semi-annually. The bond was issued 25 years ago and has 5 years to maturity. What is the value of the bond assuming 14 percent market interest rate?

2. Compute the value of a share of common stock of a company whose most recent dividend was $2.50 and is expected to grow at 6 percent per year for the next 2 years, after which the dividend growth rate will decrease to 3 percent per year indefinitely. Assume a 10 percent required rate of return.

Answer 1

Part 1) We value the bond as present value of all future cash inflows:-

PV of Interest inflows = $1,000 * (12% / 2) * Cummulative PV Factor (14%/2, 5 Years * 2) = $60 * 7.023582 = $421.41 (Approx.)

PV of Principal inflow = $1,000 * PV Factor (14%,5 Years) = $1,000 * 0.519369 = $519.37 (Approx.)

Hence, value of bond = $421.41 + $519.37 = $940.78 (Approx.)

Part 2) We value share also as PV of all future cash flows.

D₀ = $2.50 , D₁ = $2.50 * 1.06 = $2.65 , D₂ = $2.65 * 1.06 = $2.81 ,  D₃ = $2.81 * 1.06 = $2.98

PV of D₁ = $2.65 * PV factor (10%,1 year) = $2.65 * 0.909 = $2.41

PV of D₂ = $2.81 * PV factor (10%,2 year) = $2.81 * 0.826 = $2.32

PV of P₂ = D₃ / (K_e - g) * PV factor (10%,2 year) = 2.98 / (10% - 3%) * 0.826 = $42.57 * 0.826 = $35.16

Hence, value of share= $2.41 + $2.32 + $35.16 = $39.89 (Approx.)

Note- D₃ / (K_e - g) is the Gordon's Growth formula used to calculate the share price as at the end of second year.

You can find the PV Factors using the PV table available at http://www.cimaglobal.com/p1samples/

*** Please leave a comment in case of any doubt or query and i will get back to you. ***

Please hit like if this helps!