Blog: MGT201 ASSIGNMENT # 2 SOLUTION

Question stock beta#1

Vu handout page#105

Average Required ROR for all rational investors in an Efficient Market can be estimated using the CAPM Theory: Beta and Risk Free Rate of Return. 
Total Rate of Return (ROR) for Single Stock = Dividend Yield + Capital Gain. GORDON’S FORMULA FOR COMMON STOCK PRICING OR VALUATION USES REQUIRED RETURN r = DIV/Po + g. In Efficient Markets, Price of Stocks is based on Market Risk (or Beta). We can formulate the required rate of return in terms of Beta risk so how can we use beta coefficient to calculate the required rate of return for the average investor in the market. The answer to it is the

Vu handout page # 114

Po* = DIV1 / [ (rRF + (rM - rRF ) βA ) - g] 
Where
Po*=80

DIV1= 5

g= 7%

rRF = 6%

rM = 10%

βA ) ? 

Now put the values and get answer which is = βA 1.8125


Question#2
Bond valuation
Bond Pricing Equation: vu handout page#123

Bond Price = PV = C1/ (1+rD) + C2/ (1+rD) t2+ C3 / (1+rD)t3 + ….. + PAR / (1+rD)n3

Where 

Pv = bound value

C= coupon payment Pa = 2000*10.100= 200

rD= required rate of return = 14%=0.14

PAR = par value or face value= 2000

Maturity period

Bound A = t 3 n3

Bound B = t 5 n5

Answer:

(a)Bond A = value Rs: 1967

(b)Bound B= value Rs: 1928
(b)Interest rate risk
Definition
The possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time.

According to LAWARENCE J. GITMAN 12th EDITION FINANCIAL MANAGEMENT interest rate risk is the market interest rate fluctuation that directly affect the bound s value that have constant coupon payment, to reduce the fear of market interest risk diversify the portfolio as it can be spread and chose the bound with shorter duration……

So bound B is perfect decision having the shorter maturity period than bond A
................

ABC Company is considering

investing in either of the two outstanding bonds. Both bonds have Rs.2,000 par values and 10% coupon interest rates and pay annual interestsBond A has exactly 3 years to maturity, and bond B has 5 years to maturity. a)

Calculate the value of bond A if the required rate of return is 14%.b)

Calculate the value of bond B if the required rate of return is 14%.c)

If ABC wants to minimize the Interest Rate Risk, which bond should be purchased? Why. NPV Bond Pricing Equation: 

vu handout page#123

Bond Price = PV = C1/ (1+rD) + C2/ (1+rD) t2+ C3 / (1+rD)t3 +

….. + PAR / (1+rD)n3



Where Pv = Bound value 

C= Coupon payment Pa

=

2000*10.100= 200 C1 ...C2 For each year rD=

Required rate of return = 14%=0.14 PAR = Par value or face value=

2000 Maturity period Bound A =

t

3

n3 

Bound B =

t 5

n5

_________________


QQuueessttiioonn ## 0011 (10 marks)
Given the following information for the stock of Foster Company, calculate its beta.
Current price per share of common Rs.80.00
Expected dividend per share next year Rs.5.00
Constant annual dividend growth rate 7%
Risk free rate of return 6%
Return on market portfolio 10%

QQuueessttiioonn ## 0022 (20 marks)
ABC Company is considering investing in either of the two outstanding bonds. Both bonds have Rs.2,000 par values and 10% coupon interest rates and pay annual interests. Bond A has exactly 3 years to maturity, and bond B has 5 years to maturity.
a) Calculate the value of bond A if the required rate of return is 14%.
b) Calculate the value of bond B if the required rate of return is 14%.
c) If ABC wants to minimize the Interest Rate Risk, which bond should be purchased? Why.