ECOM 050, Investment Management

Tutorial 1 Answers

Question 1

A 10-year German Government bond has a face value of Є100 and an annual coupon rate
of 5%. Assume that the interest rate is 6% per year. What is the PV of the bond?

Answer:

With annual coupon payments:

PV = 5   1 − 1 
+
100 = €92.64
 10 
 0.06 0.06  (1.06)
10
 (1.06)

Question 2

Suppose that the German bond (above) makes coupon payments semi-annually like a US
bond (the bond would pay 2.5% every six months). What is the PV in this case?

Answer:

With semi-annual coupon payments:

 1
PV = 2.5  − 1  100 = €92.56
+
 
 0.03 0.03  (1.03)20  (1.03)
20
Question 3

Delta Plc has 1.5 million shares in issue which have a total market value of £1.35 million. It
has just paid an annual dividend of 9p and has constant dividend growth of 5%. It is also
partly funded by debt. The debt (each bond has a face value of £100 and 4 years left to
maturity) has a total book value of £1 million. The bonds have a coupon rate of 6% and a
yield to maturity of 8%.

a) Estimate the market capitalization rate (or expected rate of return on equity) for
Delta Plc

Answer:

Remember that, if the dividend is expected to grow at a constant rate g, then the price of the
stock is given by:

𝐷𝐷1
𝑃𝑃0 =
𝑟𝑟 − 𝑔𝑔

So, the market capitalization rate will be:

𝐷𝐷1
𝑟𝑟 = + 𝑔𝑔
𝑃𝑃0

This is the required rate of return on a company’s stock or cost of equity for the company.
Recall that, since:

𝐷𝐷1 + 𝑃𝑃1 − 𝑃𝑃0

𝑟𝑟 =
𝑃𝑃0

For dividends growing at a constant rate g, the growth rate of dividends is equal to the
capital gain:
𝐷𝐷1
𝑟𝑟 = + 𝑔𝑔
𝑃𝑃0

Where

𝑃𝑃1 − 𝑃𝑃0
𝑔𝑔 =
𝑃𝑃0
Therefore, using the DGM we have:
 D1 0.09  (1 + 0.05) 0.0945
r= +g= + 0.05 = + 0.050 = 0.155 = 15.5%
e
P0 (1.35 /1.5) 0.9

b) What is current bond price of Delta Plc’s debt?

Answer: Debt has FV=£100, CR = 6%, t = 4, YTM = 8%

6 6 6 106
Price = + 2
+ 3
+ = £93.38
1.08 1.08 1.08 1.08 4

c) What would the price of the bond be in twelve months time if the yield to
maturity at that point were risen to 10%?

Answer: Debt has FV=£100, CR = 6%, t = 3, YTM = 10%

6 6 106
Price = + 2 + = £90.05
1.1 1.1 1.13

Question 4

Horse & Buggy Plc is in a declining industry. Sales, earnings and dividends are all
shrinking at a rate of 10% per year.

a. If the return on equity is 15% and the next dividend is £3, what is the current share
price?

b. What do you expect the share price to be in one year?

Answer
D1 3 3
a. P0 = = = = 12
re − g 0.15 − (−0.10) 0.25
 D2
b. P = D1(1 + g ) 3(1 + (−0.1)) 2.7
1 = = = = 10.8
re − g re − g 0.15 − (−0.10) 0.25

Question 5

Bull Corporation has a ROE of 20%. It has a plowback ratio of 0.3 and its earnings this
year will be £4 per share. Assuming shareholders require a return of 12%

a. What is the current share price?

b. What is the current Price-Earnings-Ratio (PER)?
c. What happens to the PER if the plowback ratio was 0.2?

Answer
D1 .
a. We can use the DDM to find the current share price. i.e. P0 = r − g
e

We know re = 12%, so we need to find g and D1:

Growth rate = g = ROE x plowback ratio = 0.2  0.30 = 0.06 = 6%
D1 = Payout ratio x Earnings per share = (1 – plowback ratio) x EPS = (1 – 0.3) x 4 = 2.8
D1 2.8
So P0 = = = 46.67
re − g 0.12 − 0.06
P0 46.67
b. Price earnings ratio = = = 11.667
EPS 4

c. If the plowback ratio is reduced to 0.20 then:

g = 0.2  0.20 = 0.04 = 4%
D1 = (1 – 0.2) x 4 = 3.2
D1 3.2
So P0 = = = 40
re − g 0.12 − 0.04
P0 40
Price earnings ratio = = = 10
EPS 4

The P/E ratio falls because the firm’s value of growth opportunities is now lower: It
takes less advantage of its attractive investment opportunities, choosing to payout the
money instead.
Question 6

Pilk Plc has just paid a dividend of $2. It expects this to grow at 20% for three years. From
then on it expects growth at a constant rate of 4%. Assuming the shareholders have a
required rate of return of 15%, what is the stock price?

Answer:

The dividend discount model (DDM) will give the share price at any moment in time
provided the next dividend is one year away and dividends grow at constant growth rate
thereafter forever. So usually we have
D
P0 = r −1 g , where P0 is the price today and D1 the dividend in twelve months time.
e

In this question we only have constant growth from year four onwards, that means we can
apply the DDM in year 3, because at that point we can say the next dividend is one year
away and dividends grow at constant growth rate thereafter forever. So we have:

D
P3 = r −4g
e

Of course we want the price today. So firstly we must discount the price in year three back
to today. But recall the price in year 3 only included all the dividends from D 4 onwards.
Today’s price must include ALL future dividends, so we must also add the present value of
D1, D2 and D3 as well.

D1 = D0  (1 + g) = 2  (1+0.2) = 2.40 D2 = 2.4  1.2 = 2.88

D3 = 2.88  1.2 = 3.456
D4 = 3.456  1.04 = 3.594 (growth rate now 4%)
D 3.594
P3 = r −4 g = 0.15 − 0.04 = 32.675
e
32.675
Thus: P = D1 + D2 D3 P3 2.40 2.88 3.456 + = 28.021
+ + = + +
0
(1+ r ) (1+ r ) 2
(1+ r ) 3
(1+ r ) 3 1.15 (1.15) 2 (1.15)3 (1.15)3
Question 7

Jessy Cooper PLC currently pays a dividend of $1.22, which is expected to grow
indefinitely at 5%. If the current price (value) of JC shares based on the constant-
growth dividend discount model is $32.03, what is the required rate of return r=k?

Answer:

$1.22 (1.05)
The required return is 9%. k = + 0.05 = .09, or 9%
$32.03

Question 8

a. Computer stocks currently provide an expected rate of return of 16%. MBI, a large computer
company, will pay a year-end dividend of $2 per share. If the stock is selling at $50
per share, what must be the market’s expectation of the growth rate of MBI
dividend?
b. If the dividend growth forecasts for MBI are revised downward to 5% per year, what will
happen to the price of MBI stock?

Answer:

a. D1
k= +g
P0
$2
0.16 = + g  g = 0.12, or 12%
$50

D1 $2
b. = = = $18.18
P0 k − g 0.16 − 0.05
The price falls in response to the more pessimistic dividend forecast. The
forecast for current year earnings, however, is unchanged. Therefore, the P/E
ratio falls. The lower P/E ratio is evidence of the diminished optimism
concerning the firm's growth prospects.
Question 9

a. MF Corporation has an ROE of 16% and a plowback ratio of 50%. If the coming year’s
earnings are expected to be $2 per share, at what price will the stock sell? The
market capitalization rate is 12%.
b. What price do you expect MF shares to sell for in 3 years?

Answer:

a. g = ROE  b = 16%  0.5 = 8%

D1 = $2  (1 – b) = $2  (1 – 0.5) = $1
D1 $1
P0 = = = $25.00
k − g 0.12 − 0.08

b. P3 = P0(1 + g)3 = $25(1.08)3 = $31.49

Question 10

If a security is underpriced (i.e. its intrinsic value>price), then what is the relationship
between its market capitalization rate and its expected rate of return?

Answer:

The intrinsic value of a share of stock is the individual investor’s assessment of the
true worth of the stock. The market capitalization rate is the market consensus for the
required rate of return for the stock. If the intrinsic value of the stock is equal to its
price, then the market capitalization rate is equal to the expected rate of return. On the
other hand, if the individual investor believes the stock is underpriced (i.e., intrinsic
value > price), then that investor’s expected rate of return is greater than the market
capitalization rate.