MGT201 Financial Management Assignment No. 2 Solution Idea Spring Semester 2014

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MGT201 Financial Management Assignment No. 2 Solution Idea Spring Semester 2014


Case
Assume that recently, you have been appointed as assistant to the financial analyst of
the company named: XYZ and management of the company is now expected you to
do some required calculations in the need to make few important financial decisions.
Company formerly issued few common stocks and bond with which the related
information is as given below:

A 10 years bond of par value Rs.8,000/- was issued, with annual coupon
interest rate of 11.5%. Required rate of return on such bonds is 9% p.a.
Stock A was issued by the company, for which they have paid Rs.1.25 per stock
as annual dividend, this year. Company’s earnings and divided is expected to
grow at 6.5% in a year ahead.
Stock B was issued by the company, for which the required rate of return is
17%; beta is 1.5 while the market return is 15.5%.
Stock C was issued by the company, for which the risk free rate of return is
11.5%; market risk premium is 2.3% and required rate of return is 16.2%.

Required

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1. Keeping in view the given information, calculate the value of the bond.
[4 marks]
2. Calculate and comment, how the value of the bond will be affected, if the
required rate of return on bond is increased up to 13 %. [3 marks]
3. Using SML equation, you need to find out the risk free rate of return for
stock B. Also interpret the result of stock B for investment purpose. [3 marks]

[education-2014]

question No. 01

Par Value = Rs. 8,000

Coupon Rate =11.5 %

Required Rate of return, i = 9 %

Coupon payment = Coupon Rate * Par Value
= 0.115 * 8,000 = Rs. 920

Present value of Par value = 8,000 / (1+0.09)10

=8,000 / (1.09)10

= 8000/2.3673 = Rs. 3379.38 …………….. (A)

….> to calculate the present value of the coupon payment present annuity formula is used.

Present value of the coupon payments = 920 [1 – 1/ ( 1+0.09 )10 ]/ 0.09
=920 [1 – 1/ (1.09)10]/ 0.09
=920 [ 1 – 0.4224]/ 0.09

= 920 * [0.5775] / 0.09

= Rs. 5903.272 ……………… (B)
Adding (A) & (B)

Value of bond = 3379.38 + 5903.272 = 9282.652 Rs.



Question No. 02

Par Value = Rs. 8,000

Coupon Rate =11.5 %

Required Rate of return, i = 13 %
Coupon payment = Coupon Rate * Par Value

= 0.115 * 8,000 = 920 Rs.

Present value of Par value = 8,000 / (1+0.13)10

=8,000 / (1.13)10

= 8000/3.3945

= Rs. 2356.71 ………. (A)

Present value of the coupon payments = 920 [1 – 1/ ( 1+0.13 )10 ]/ 0.13

=920 [1 – 1/ (1.13)10]/ 0.13

=920 [ 1 – 0.2946]/ 0.13

= 920 * [0.7054] / 0.13

= Rs. 4992.012 . ……………… (B)

Adding (A) & (B)

Value of bond = 2356.71 + 4992.012 = 7348.722 Rs.

Comments :

When the required rate of return of the investor increases, the value of the bond decrease.this is called the interest rate risk.when the investor sees that the investment is riskier in response of that he increases its ROR.



Question No. 03

Required rate of return of stock B, rB = 17 %

Market Return , rM = 15.5 %

Beta, βB = 1.5

Risk free rate of return , r RF = ?

rB = r RF +( rM - r RF ) βB

17 % = r RF + (15.5% - r RF) * 1.5

17 % = r RF + 23.25%- 1.5 r RF

17 % = 23.25%- 0.5 r RF

0.5 r RF = 6.25 %

r RF = 6.25 % / 1.5

r RF = 12.5 %

Interpretation of Result:

Investor’s required rate of return is 17% in the investment of stock B which is higher than the market rate of return 15.5 %.because the stock(beta=1.5) is riskier than the market (beta =1.0)

So the investor will not invest in the stock B because It would not bring the required return for the investor