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Financial Management Assignment

EXECUTIVE SUMMARY:

This report presents Bond valuation, valuation of price of stock on the basis of unusual dividend growth rate and Gordon growth model, Capital budgeting decision on the basis of NPV and payback period, portfolio management and calculation of expected return, risk, selection of securities on the basis of Capital Asset Pricing Model.

TABLE OF CONTENTS:

Solution1                                                                                                                           3-4

Solution 2                                                                                                                           5-6

Solution 3       & ........

of Capital Asset Pricing Model.

TABLE OF CONTENTS:

Solution1                                                                                                                           3-4

Solution 2                                                                                                                           5-6

Solution 3                                                                                                                           7-8

Solution 4                                                                                                                           9-10

Solution 5                                                                                                                         11-13

Solution 6                                                                                                                         14-15

Solution 1:

Given,

Coupon rate = 7%

Required rate of yield = 13%

Since the interest payment is semiannual, the coupon rate and the required rate of yield will be half of the given rates.

Interest component every half year = $1000*3.5% = $35

Calculation of present value of bond:

Period

Interest @3.5% ($)

Present Value Factor 6.5%

Present Value ($)

1

35

0.9389

32.8615

1.5

35

0.8817

30.8595

2

35

0.8278

28.973

2.5

35

0.7773

27.2055

3

35

0.7298

25.543

3.5

35

0.6853

23.9855

4

35

0.6435

22.5225

4.5

35

0.6042

21.147

5

35

0.5674

19.859

5.5

35

0.5327

18.6445

6

 

0.5002

0

6.5

 

0.4697

0

7

 

0.441

0

7.5

 

0.4141

0

8

 

0.3888

0

8.5

 

0.3651

0

9

35

0.3428

11.998

9.5

35

0.3218

11.263

10

35

0.3022

10.577

10.5

35

0.2837

9.9295

11

35

0.2664

9.324

11.5

35

0.2502

8.757

12

35

0.2349

8.2215

12.5

35

0.2206

7.721

13

35

0.2071

7.2485

13.5

35

0.1945

6.8075

14

35

0.1826

6.391

14.5

35

0.1715

6.0025

15

35

0.161

5.635

15.5

245#

0.1512

37.044

Total

398.5205

 

# since the company has skipped six semiannual payments which is to be paid at maturity so the total payment at maturity is $35*7 = $245.

Therefore the corporate bond’s value of AIMCOR Limited is $398.5205.

Solution 2:

Given,

D0 = $4 per share
Required rate of return (k) = 10% 
g1 (dividend growth rate, year 1) = 20%
g2 (dividend growth rate, year 2) = 15%
g3 (dividend growth rate, year 3) = 10%
gn (dividend growth rate thereafter) = 5%

Since we have estimated the dividend growth rate, we can calculate the actual dividends for those years:
D0 = $4
D1 = $4 * 1.20 = $4.80
D2 = $4.80 * 1.15 = $5.52 
D3 = $5.52 * 1.10 = $6.072

We then calculate the present value of each dividend during the unusual growth period:
$4.80 / (1.15)1 = $4.1739
$5.52 / (1.15)2 = $4.1739
$6.072 / (1.15)3 = $3.9924
 
 
Then, we value the dividends occurring in the stable growth period, starting by calculating the fourth year's dividend: 
D4 = $6.072*(1.05) = $6.3756

We then apply the Gordon Growth Model formula to these dividends to determine their value in the fourth year:

Value of stock = D1/ (k - g)
where:
D1 = next year's expected annual dividend per share
k = the investor's discount rate or required rate of return
g = the expected constant dividend growth rate

 $6.3756 / (0.15-0.05) = $63.756

The present value of these constant growth period dividends are then calculated:
$63.756 / (1.15)4 = $36.4527

Finally, we can add the present values of future dividends to arrive at the current value of stock:
$4.1739+$4.1739+$3.9924+$36.4527 = $48.7929

Thus, the share of Storico will sell for $48.7929 today.

Solution 3:

  1. NPV of the project = present value of cash inflows – initial cash outflow

Initial Cash Outflow = $6.5 Million

Calculation of Present value of future cash inflows:

Period

Cash Inflows ($ Million)

P.V. factor (10%)

Present value ($ Million)

Year 1

3

0.9091

2.7273

Year 2

3

0.8264

2.4792

Year 3

3

0.7513

2.2539

Year 4

3

0.6830

2.0490

Year 5

3

0.6209

1.8627

TOTAL INFLOWS

11.3721

 

NPV = $11.3721 Million - $6.5 Million = $4.8721 Million

NPV of the project is positive. NPV rule says that if the NPV of the project is 0 or greater than 0 then only project should be accepted. Here, the NPV is $4.8721 Million so the project should be accepted.

  1. If I take the project, the value of firm will increase by $4.8721 Million as the profit of firm will increase by $4.8721 Million.
  2. Calculation of payback period

 

Payback Period:   Initial Outflow___

                             Annual cash inflow

Calculation of Cumulative Cash Inflows:

Period

Cash Inflows ($ Million)

Cumulative cash Inflows ($ Million)

Year 1

3

3

Year 2

3

6

Year 3

3

9

Year 4

3

12

Year 5

3

15

 

Payback Period = 2 + (6.5-6) = 2+0.17 = 2.17 years

                                        3

It means we are at Break Even Point in the 2.17 Years. There is a weakness in this method. This method is ignoring the return after the payback period.

Solution 4:

Using,

Expected return of the Portfolio E(R) = E1*W1 + E2*W2

Where,

E1 = Expected return on security 1

E2 = Expected return on security 2

W1 = Weight of security 1

W2 = Weight of security 2

And,

Portfolio Variance (σ2p) = w2A*σ2(RA) + w2B*σ2(RB) + 2*(wA)*(wB)*RAB* σ(RA)* σ(RB)


Where,

 wA and wB are portfolio weights,

 

σ2(RA) and σ2(RB) are variances and 


RAB is the correlation coefficient between Securities


Case1: If 20% of money is added in Stock A and remaining 80% in the existing portfolio

E (R) = (18%*0.80) + (15%*0.20) = 14.4% + 3% = 17.4%

(σ2p) = (0.80)2*(30%)2+(0.20)2*(25%)2+2*0.80*0.20*0.2*30%*25%

(σ2p) = 576+25+48

(σ2p) = 649

(σp) = (649)1/2

           = 25.4754%

Case2: If 20% of money is added in Stock B and remaining 80% in the existing portfolio

E (R) = (18%*0.80) + (15%*0.20) = 14.4% + 3% = 17.4%

(σ2p) = (0.80)2*(30%)2+(0.20)2*(20%)2+2*0.80*0.20*0.6*30%*20%

(σ2p) = 576+16+115.2

(σ2p) = 707.2

(σp) = (707.)1/2

           = 26.5932%

Considering that the return in both the above cases is same, the risk is lower in Case 1 as compared to Case 2. So, I will invest in Stock B considering the lower risk.

Solution 5:

  1. Expected Return of Intel Stock:

Using Capital Asset Pricing Model (CAPM):

Ra = Rf + [Ba x (Rm – Rrf)]

Where:

Ra = Expected return on a security
Rf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on market

Given,

Rf = 5%

Ba = 1.8

Rm = 10%

Expected Return on Intel Stock = 5% + [1.8 x 10%] = 23%

  1. Expected Return of Boeing Stock:

Using Capital Asset Pricing Model:

Ra = Rf + [Ba x (Rm – Rrf)]

Where:

Ra = Expected return on a security
Rf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on market

Given,

Rf = 5%

Ba = 1.2

Rm = 10%

Expected Return on Boeing Stock = 5% + [1.2 x 10%] = 17%

 

 

  1. Beta of a Portfolio (Bp) = B1*W1+B2*W2+…..+BN*WN

B1 = Beta of security 1

B2 = Beta of security 2

BN = Beta of security N

W1 = Weight of security 1

W2 = Weight of security 2

WN = Weight of security N

Given,

B1 = 1.8

B2 = 1.2

W1 = 0.70

W2 = 0.30

So, Bp = (1.8*0.70) + (1.2*0.30) = 1.26+0.36 = 1.62

Thus, the beta of portfolio that consists of 70% of Intel stock and 30% of Boeing stock is 1.62

Expected return of the Portfolio E(R) = E1*W1 + E2*W2

Where,

E1 = Expected return on security 1

E2 = Expected return on security 2

W1 = Weight of security 1

W2 = Weight of security 2

E (R) = (20%*0.70) + (25%*0.30) = 14% + 7.5% = 21.5%

So, the expected return of the given portfolio is 21.5%

  1. Given,

Expected return on Intel stock = 20%

Expected return on Boeing stock = 25%

Expected return on Intel stock using CAPM (From part a) = 23%

Expected return on Boeing stock using CAPM (From part b) = 17%

I should buy Intel stock as this security is undervalued being the expected return on this security is less than the expected return calculated using Capital Asset Pricing model and therefore this stock will give me good returns.

I should sell Boeing stock as this security is overvalued being the expected return on this security is more than the expected return calculated using Capital Asset Pricing model and therefore this stock will not give me good returns.

Solution 6:

Capital Asset Pricing Model (CAPM):

Ra = Rf + [Ba x (Rm – Rrf)]

Where:

Ra = Expected return on a security
Rf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on market

Given,

Rf= 3%

Ba=1.2

Rm= 6%

Ra= 3% + [1.2 x(6% - 3%)]

     = 6.6%

So, the expected return on Apple is 6.6 %

Apple’s Price at the beginning of 2013 = $75

Apple’s Price at the end of 2013 = $80

Return on Apple at the end of 2013 = $80-$75 = $5

Return on Apple at the end of 2013(%) = ($5/$75)*100 = 6.67%

The CAPM formula is used for calculating the expected return on an investable asset. The Apple’s managers exceed the investors’ required rate of return by (6.67-6.60) % = 0.07%. The actual return is more than the expected return calculated by CAPM model so the stock of Apple is undervalued therefore investors can go long in this security.