Suppose, presently three prominent investment opportunities are prevailing in th

Question

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.
¾ 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%.
¾ 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%.
¾ 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 anal ysis 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:
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Explanation / Answer

(a) Value of companys stock The formula to be used = Dividend (1+ dividend growth rate)/required rate of return-dividend growth rate = 4.2(1+0.07)/0.13-0.07 = Rs74.9 answer (b) First we will have to calculate the required rate of return using Gordon-SML equation method Required rate of return = risk free rate + beta (market rate of retunr - risk free rate) Required rate of return = 10 + 2(15-10) = 20% The Ideal value should be = Dividend (1+ dividend growth rate)/required rate of return-dividend growth rate = 4.6(1+0.085)/0.2-0.085 = Rs 43.4 Since the stock value should be Rs 43.4 but it is Rs 30 currently, it means that the stock is undervalued. (c) Company C intrinsic value of the bond Formula to be used =(140/5)/ (1+0.16/4)^20 + 1000/(1.16^5) = Rs 492.0866 (d) As per the analysis, The investor can buy Company A stock, as the current value of stock is Rs74.9 but it is selling for Rs60.5. You can expect to earn profit in the future as the stock is undervalued and you can ear money. 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 Rs492.0866 but is being sold for Rs 850 in the market. The bond looks expensive. You can earn more by investing your money in bank deposits rather than investing in bond (e) 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% Hope this clarifies Happy to help

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