Assignment#01 Marks 20
Stock valuation and Bond Valuation
Bonds and stocks are two primary securities traded on approximately all stock exchanges of the world because of its potential, reliability, and better trade volume. Besides all these pro, risk taking behavior of different investors and the features associated with each class of security are vital ones that attract investors for earning a handsome return. Stocks are considered more risky with higher return, whereas bonds accounted low risk investment with guaranteed return. However, most investors formulate a portfolio of their investment with combination of bonds and stocks for optimal return with a lesser degree of risk due to diversification edge involved in it. The formulation of such portfolio lies upon market factors and company specific factors. The optimal return only can be achieved by better judgment of both factors and evaluation of intrinsic prices of securities by some fundamental methods.
Required: A new investor wants to add bonds and shares in his portfolio and he has two options available with the following information.
I. Company ABC issued a five-year bond with face value of Rs.1,000. The bond offers 12% semiannual coupon payment. The market interest rate for such type of investment is 14% per annum while current market price of bond is Rs.940.
II. The stock of company XYZ is being sold at Rs.54 per share while the forecasted dividend is Rs.6 for first year and Rs.7 for the second year. The price of the stock after year 2 is expected to be Rs.55. The Company paid most recent dividend as Rs.5 whereas the rate of return for such type of investment is 14% per annum.
You are required to help the investor in valuation of both investment options by calculating:
1. Intrinsic value of the bond. (8 marks) 2. Intrinsic Value of stock today. (8 marks) 3. Identify either bond and stocks are overvalued or undervalued. Justify your answer with proper calculation and reasoning. (4 Marks)
1. Intrinsic value of the bond.
PV = Intrinsic Value of Bond or Fair Price (in rupees) paid to invest in the bond. It is the Expected or Theoretical Price and NOT the actual Market Price.
PV= ∑ CFt / (1+r D )t =CF1/(1+r D )+CFn/(1+r D )2 +..+CFn/ (1+r D ) n +PAR/ (1+r D ) n
This is correct formula
Question no 2
Dividend year 1= Rs 6
Dividend year 1= Rs 7
Price of stock after 2 years= Rs 55
Rate of return = 14% per annum.
PV=6/1.14 + 7/(1.14)2 + 55/(1.14)2
=5.26 + 5.39 + 42.32 = Rs 52.97
stock is undervalued as the face value that is Rs 54 which is more than market value that is Rs 52.97
Question no 1
Face value of bond= Rs 1000
Interest rate(rD)=12% semi annually
Market price of Bond= Rs 940
Market Interest Rate=14% per annum
CF = Cash Flow = Coupon Value
= Coupon Rate x Par Value
=0.12*2*1000= Rs 240
PV=240/1.14 + 240/(1.14)2 + 240/(1.14)3 + 240/(1.14)4 + 240/(1.14)5 + 1000/(1.14)5
Bond is undervalued as the face value that is Rs 1000 which is more than market value that is Rs.940