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CASE :-

Suppose, presently three prominent investment opportunities are prevailing in the stock market and being an investor Mr. Hamid is interested to investigate that which of these investments, he should choose to develop his own portfolio. Right now, following information is easily available in the market regarding these investments.

Company A is trading its common stocks in the Karachi Stock Exchange (KSE). It is currently paying Rs. 4.20/- as dividend on each stock and selling it for Rs. 60.50 in the market at the end of one period. The expected growth rate of this dividend is 7%. Investor’s expected rate of return on this stock is 14%.

Company B is trading its perpetual common stock at Rs.30/- in the KSE and paying Rs. 4.6/- as dividend on each share. Face Value of the share is Rs.10/-. Expected Growth Rate of Dividends is 8.5%. Risk free rate of return (rrf) is 10%. Rate of return based on the value of the KSE 100 Index (rm) is 15%; return on common stock of Company B is relatively volatile as reflected by the company’s beta 2. Investor’s expected rate of return on this stock is 19%.

Company C is selling 5-year bond at Rs. 850/- in the market with 14% coupon paid quarterly. Face value of the bond is Rs. 1,000/-. Expected rate of return on this bond is 15.5% and required rate of return is 16%.

You are required to:

a) Analyze the value of Company A’s stock, if the required rate of return on the stock is 13%. (7 Marks)

b) Estimate ‘Fair Price’ of Company B’s stock by using Gordon-SML Equation and analyze whether the stock is undervalued or overvalued in the market. (8 Marks)

c) Calculate the intrinsic value of Company C’s bond by using available information. (7 Marks)

d) Suggest that which of the investment options, Mr. Hamid should opt and why? (As per the results of analysis done in above three sections). (3 Marks)

e) Calculate the expected return of Mr. Hamid’s portfolio, assuming that he has 5 lac rupees as total investment and he is interested to make equal investment in each security accepted in section (d). (5 Marks)

(Note: You need to show complete step-wise working along with formulae; otherwise marks will be deducted).

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### Replies to This Discussion

1-Analyze the value of Company A’s stock, if the required rate of return on the stock is 13%.

Value of stock = Dividend (1+ dividend growth rate) / required rate of return-dividend growth rate.

Value of company’s stock = 4.2 01+0.07) / 0.13-0.07
Value of company’s stock = 4.20(1.07) / 0.06
Value of company’s stock = 4.494 / 0.06
Value of company’s stock = 74.9

2-Estimate ‘Fair Price’ of Company B’s stock by using Gordon-SML Equation and analyze whether the stock is undervalued or overvalued in the market.

Required rate of return = risk free rate + beta (market rate of return - risk free rate)
Required rate of return = 10 + 2(15-10)
= 10 + 2(5)
= 10 + 10
Required rate of return = 20%

Ideal value = Dividend (1+ dividend growth rate) / required rate of return-dividend growth rate
= 4.6 (1+0.085) / 0.2 - 0.085
= 4.6 (1.085) / 0.115
= 4.991 / 0.115
Ideal value = 43.4

Current stock value is RS 30; it must be RS. 43.4 means that the stock is undervalued

3- Calculate the intrinsic value of Company C’s bond by using available information

Intrinsic value of Company C’s bond

= (140/5) / (1+0.16 / 4)^20 + 1000 / (1.16)^5
= 488.89

4-Suggest that which of the investment options, Mr. Hamid should opt and why? (As per the results of analysis done in above three sections).

As per the analysis, the investor can buy Company’s stock, as the current value of stock is Rs74.9 but its selling price is Rs. 60.5. Stock price is undervalued but Mr Hamid can expect to earn profit in the future

The investor should buy Company B stock, as the current value of the stock is Rs 43.4 but it is being sold in the market for Rs30. You can expect appreciation in the value of the stock in the future and can gain.
The investor should not buy Company C bond, as the fair value of the bond today is Rs488.89 but is being sold for Rs 850 in the market.

5-Calculate the expected return of Mr. Hamid’s portfolio, assuming that he has 5 lac rupees as total investment and he is interested to make equal investment in each security accepted in section (d).

Assuming that he is investing Rs250000 in Company A and Rs250000 in Company B

Return on Company A stock = 14% * 250000 = Rs35000
Return on company b stock = 19% * 250000 = Rs47500

Return on portfolio = 35000+47500/500000 = 16.5%

M.Tariq Malik 250,000 kasy liya hy yahan 500,000 lac ny aye ga kia....please koi to bta day

250000 for each project . total comes out to be 5 lac as you said... its correct

thanks dear

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