Question

Cassey Computer Ltd. has an outstanding issue of bond with a par value of $1,000, paying 8 percent coupon rate semi‑annually.  And, the company just paid a dividend of $2.70 per share. The dividends are expected to grow at 5.0 percent for next 2 years. i.e. year 1 and 2, and after year 2, dividends are estimated to grow at 4 percent thereafter indefinitely.  Based on market information, government bond’s yield for 10-year maturity is 5 percent, market expected return is 15 percent, and beta of Cassey’s stock is 1.5.  Assume no market friction and taxes.

Required:

1. The bond of Cassey Computer Ltd. was issued 25 years ago and has 5 years to maturity. What is the value of the bond assuming 10 percent rate of current interest rate?

2. If interest rate is expected to decrease, what characteristics and types of bonds would have better performance?

3. Assume that the forecasted dividends and the required return are the same one year from now, as those forecasted today.  What is the expected intrinsic value of the stock one year from now, just after the dividend has been paid in year one?

Answer 1

a. Value of the bond

Value of the bond is $922.78

b. if interest rate is expected to decrease, what characteristics and types of bonds would have better performance?

Generally if the interest rate falls, value of the bond increases mainly in case of fixed coupon bonds since people will get higher coupons with the fixed interest rate than the current falling rates. Thus, if the bond is for a higher term and interest rate is fixed and if the interest rate is expected to decrease, these bonds would fare better and the prices tend to increase.

However, from the perspective of the company issuing the bonds, if the interest rate expected to reduce, they would like to call the current bond as it involves paying at a higher rate. Thus, for the company issuing the bond, if the bond is for a shorter term (shorter duration will help them to close out the bond liability earlier) or if the interest are linked to index (like LIBOR, etc), these type of bonds would be beneficial for the issuing company.

c. What is the expected intrinsic value of the stock one year from now, just after the dividend has been paid in year one

First find the cost of equity of the company.

Cost of equity under CAPM (Capital Asset Pricing Model) = RF+(B*(RM-RF)) where

RF = risk free rate = 5% (yield of government bond)

B = Beta = 1.5

RM = Market Return = 15%

Cost of equity = 5%+(1.5*(15%-5%)) = 5% + 15% = 20%

Intrinsic value of share in Year 1= Dividend next year/ (cost of equity - growth rate)

Dividend next year = Dividend in year 2 (since the value to be computed is in Year 1)

Dividend now = $2.7

Growth rate for 2 years= 5%

Dividend in Year 1 = $2.7*(1+5%) = $2.835

Dividend in Year 2 = $2.835*(1+5%) = $2.9768

Growth rate = 4% (perpetual growth rate)

Intrinsic value of share in Year 1 = $2.9768 / (20%-4%) = $18.605 or $18.61