Question

Assignment 2 Rodomontade is an investment firm specialising in corporate advice, particularly in regard to raising finance and company valuation. One of its clients, Donald Rump, the CEO of Rump Industries Ltd, has approached Rodomontade seeking advice and assistance. Question 1 Rump Industries Ltd is a large company listed on The Bahamas Stock Exchange. It is a diversified company with manufacturing and trading divisions operating in a number of industries. Rump has recently developed a new product which is the first of its kind and which is expected to make a significant contribution to the company’s future earnings. Rump needs additional finance to bring the product to market. The company is seeking to raise $40 million in debt finance through a bond issue. Rump would like to issue bonds with a face value of $1000, a maturity of 20 years and an 8 per cent annual coupon rate. Interest would be paid semi-annually. Rump is considering offering an 8 per cent coupon because it is not sure what rating its bonds would receive. Rodomontade has advised that similar bonds with an AA rating currently have a yield to maturity of 7.5 per cent and similar bonds with an A rating have a yield to maturity of 8.5 per cent. Required:

(a) Calculate the price of the bonds, and the number of bonds Rump would need to issue, if the company was to receive an AA rating (2.5 marks)

(b) Calculate the price of the bonds, and the number of bonds Rump would need to issue, if the company was to receive an A rating (2.5 marks)

Question 2 Rump Industries Ltd expects its new product will give it a significant first mover advantage in the market and that is expected to provide growth in earnings per share of 400% within the coming year, and 75% growth in each of the subsequent 3 years. After that time, it is expected competitors will have developed and brought to market similar products with the result that Rump would expect earnings growth to drop back to its normal level of 3% per year forever. Rump’s cash dividend was 10 cents per share last year and is expected to remain at that amount for each of the next 5 years as the company builds it’s retained earnings to finance research and development. In the sixth year, it is expected shareholders will be rewarded with a payout ratio that will be 80% of the earnings per share, and the payout ratio is expected to remain at that level forever. The required rate of return on Rump’s ordinary shares is 20% per year and the latest earnings per share was 25 cents. Required:

(a) Calculate the price that Rump Industries Ltd ordinary shares should be selling for in the market, assuming Rump’s growth projections are accurate. (2.5 marks)

(b) Rodomontade is concerned that Rump’s earnings growth projections, as a result of the new product, might be too optimistic in the first four years. Rodomontade is in favour of a more conservative approach and recommends the growth rates should be half (i.e. reduced by 50%) of Rump’s projections before growth returns to its normal 3% level. Calculate the price that Rump Industries Ltd ordinary shares should be selling for in the market, using Rodomontade’s growth projections. (2.5 marks

Answer 1

1a). FV = 1,000; N = 20*2 = 40; PMT (semi-annual coupon) = annual coupon*par value/2 = (8%*1,000)/2 = 40; rate (semi-annual YTM) = 7.5%/2 = 3.75%, solve for PV.

Price (if bond is rated AA) = 1,051.38

Number of bonds to be issued = total amount to be raised/issue price = 40,000,000/1,051.38 = 38,045.33

1b). FV = 1,000; N = 20*2 = 40; PMT (semi-annual coupon) = annual coupon*par value/2 = (8%*1,000)/2 = 40; rate (semi-annual YTM) = 8.5%/2 = 4.25%, solve for PV.

Price (if bond is rated A) = 952.31

Number of bonds to be issued = total amount to be raised/issue price = 40,000,000/952.31 = 42,003.27

2a). Price per share = 13.74

2b). Price per share = 4.21