Valuation Bond Stock CASE: Early in 2004, Mr. Zahid Hussain, the chief financial
ID: 2502263 • Letter: V
Question
Valuation Bond Stock
CASE:
Early in 2004, Mr. Zahid Hussain, the chief financial officer for SNT Manufacturing Company was
given the task of assessing the firm’s bond and stock values. To perform the necessary analysis,
Mr. Zahid gathered the following relevant data on the firm’s bonds and stocks.
BONDS: The firm has a Rs. 1,000 par value bond with an 8 percent coupon interest rate outstanding. The bond has 12 years remaining to its maturity date.
STOCKS: The firm’s common stock currently pays an annual dividend of Rs. 1.80 per share. The required return on the common stock is 12 percent.
REQUIRED:
a.If interest is paid annually, what is the value of the bond when the required stated
return is:
(1) 7 percent
(2) 8 percent
(3) 10 percent
B.Indicate for each case in part a whether the bond is selling at a discount, at a premium, or at its par value.
C.Using the 10 percent required return, find the bond’s value when interest is paid semiannually
d. Estimate the value of common stock under each of the following dividend-growth-rate
Assumptions:
(1)Dividends are expected to grow at an annual rate of 0 percent to infinity.
(2)Dividends are expected to grow at a constant annual rate of 5 percent to infinity.
(3)Dividends are expected to grow at an annual rate of 5 percent for each of the next 3 years followed by a constant annual growth rate of 4 percent in years 4 to infinity.
Explanation / Answer
a) Calculating Value of the Bond using different RequiredStated Returns
BondValue = C * [1-1/(1+r)t] / r +F/(1+r)t
C = Coupon Payment (1000* 8% = Rs.80)
t = Number of years to maturity = 12 years
i) Required Stated Return is7%
B0 = 80 * [1-1/(1.07)12] / 0.07 +1000/(1.07) 12
= 80 * [1-1/2.25219] / 0.07 +1000/2.25219
= 80 * [1-0.4440] / 0.07 + 1000 /2.25219
= 80 * [0.556 / 0.07] + 444
= 80 * (7.9428) + 444
= 635.42 + 444
ii) Required Stated Return is8%
B0 = 80 * [1-1/(1.0812] / 0.08+1000/(1.08 12
= 80 * [1-1/2.51817] / 0.08 +1000/2.51817
= 80 * [1-0.397113] / 0.08 +397.113
= 80 * [0.602887/0.08] +397.113
= 80 (7.5360875)+ 397.113
= 602.887 +397.113
iii) Required Stated Return is10%
B0 = 80 * [1-1/(1.1012] / 0.10+1000/(1.10) 12
= 80 * [1-1/3.13842] / 0.10 +1000/3.13842
= 80 * [1-0.31863] / 0.10 + 318.63
= 80 * [0.68137 / 0.10] + 318.63
= 80 (6.8137) +318.63
= 545.096 + 318.63
c) Calculating the bond value at10% required return when the interest paymentare semi-annually
If the Interest payments are semi-annual the coupon payment is =1000 * 8/2 % = Rs.40
Required Return Rate = (10/2 %) 5%
B0 = 40 [1-1/(1.05)12*2] / 0.05 +1000/(1.05) 12*2
= 40 [1-1/3.225099] /0.05 + 1000/3.225099
= 40 [ 1-0.310068] / 0.05 +310.068
= 40 [ 0.689932 / 0.05] +310.068
= 40 [13.79864] + 310.068
= 551.94 + 310.068
(d) Estimating the Value of the CommonStock:
Dividend paid(D0) = Rs.1.80 per share
D1 = D0 * (1+g)
= 1.80 * (1+0)
= 1.80 * 1
= Rs.1.80
P0 = 1.80 / 0.12
= Rs.15
ii)Dividends are expected to grow at aconstant annual rate of 5%
P0 = {D1 / (Re – g)}
D1= D0 * (1+g)
=1.80 * (1+5%)
= 1.80 * (1+0.05)
= Rs.1.89
P0 = 1.89 / (12% - 5%)
= 1.89 / (0.12 – 0.05)
= 1.89/0.07
= Rs.27
iii)Dividends are expected to grow atan annual rate of 5% for each of the next 3 years followed by aconstant annual growth rate of 4% in 4 years
P0 = {D1 / (Re – g)}
D1= D0 * (1+g)
= 1.80 * (1+0.04)
= Rs.1.872
P0 = 1.872 / (12% - 4%)
= 1.872 / 0.08
= Rs.23.40
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