Accounting and Finance Global Edition

Question: Discuss about the Accounting and Finance for Global Edition. Answer: 1. Value of the bond Face value = $ 1,000 Coupon rate = 8.75% Hence, annual coupon = $ 87.5 Maturity period = 12 years Required return on bond = 6% The value of the bond as per the above information is given below (Damodaran, 2008). Year Coupon Payment Principal Repayment Total inflow PV factor PV ($) 1 87.5 87.5 0.943 82.55 2 87.5 87.5 0.890 77.87 3 87.5 87.5 0.840 73.47 4 87.5 87.5 0.792 69.31 5 87.5 87.5 0.747 65.39 6 87.5 87.5 0.705 61.68 7 87.5 87.5 0.665 58.19 8 87.5 87.5 0.627 54.90 9 87.5 87.5 0.592 51.79 10 87.5 87.5 0.558 48.86 11 87.5 87.5 0.527 46.09 12 87.5 1000 1087.5 0.497 540.45 Total 1230.56 The value of the bond is $ 1,230.56. Value of Preference Shares Annual dividend paid = $ 2.5 Return expected = 7% pa Hence, value of this investment = 2.5/0.07 = $ 35.71 Value of Shares The appropriate method to be used here is the Gordon Dividend Discount Model (Parrino Kidwell, 2011). Value of share = Dividend next year /(Required return Growth rate in Dividends) Growth rate in EPS = (3.06/1.49)(1/5) -1 = 15.48% Dividend to be paid next year = 1.32*(1.1548) = $ 1.524 However, since the dividend growth rate is more than the required return, hence the theoretical price of the share would be potentially infinite. 2. Investment in bond would not be made since the actual market price at $1,314 is greater than the intrinsic value of $ 1,230.56. Hence, the current rate derived on the bond is lesser than 6%. However, in the future if the required return decreases then a fresh assessment may be done. Investment in preference shares would be done as the market value of these is $ 25.5 and thus lesser than the intrinsic value of $ 35.7. As a result, the actual return earned on the preference share is greater than 7% (Parrino Kidwell, 2011). Actual return on preference share = (2.5/25.50)*100 = 9.8% pa Investment in shares would be made as the current market value of the shares at $ 36.75 Is significantly lesser than the intrinsic price expected. Assuming the given price as the intrinsic price, the actual return is calculated below (Brealey, Myers Allen, 2008). 36.75 = 1.524/(x-0.1548) Solving the above, we get, x = 19.63% pa However, it is noteworthy that the assumed growth rate in excess of 15% does not seem feasible and in actuality it would be lesser thus adversely impacting the intrinsic price. Summary Investment in bonds should not be done as at current market price, the return would be lesser than the required return. However, based on the given information, the returns on the other two investments i.e. preference shares and shares would be higher than the respective required return. 3. Earnings downturn expected to the tune of 3% pa Hence, dividend growth rate = -3% Next year dividend = 1.32*(1-0.03) = $ 1.2804 Value of share = Dividend next year /(Required return Growth rate in Dividends) Intrinsic value of share = 1.2804/(0.15-(0.03)) = $ 7.11 It is known that the current market price of the share is $ 36.75. The share is currently overpriced as the actual price should not be $ 7.11. Hence, the share should not be bought at the current price (Petty et. al., 2015). 4. Required return calculation for bonds Face value = $ 1,000 Coupon rate = 8.75% Hence, annual coupon = $ 87.5 Maturity period = 12 years Current market price of the bond = $ 1,314 Let the required return on bond based on the above data be x% The required return can be estimated using the below mentioned table (Damodaran, 2008). Year Coupon Payment Principal Repayment Total inflow PV factor PV ($) 1 87.5 87.5 0.951 83.20 2 87.5 87.5 0.904 79.10 3 87.5 87.5 0.860 75.21 4 87.5 87.5 0.817 71.51 5 87.5 87.5 0.777 68.00 6 87.5 87.5 0.739 64.65 7 87.5 87.5 0.703 61.47 8 87.5 87.5 0.668 58.45 9 87.5 87.5 0.635 55.58 10 87.5 87.5 0.604 52.84 11 87.5 87.5 0.574 50.24 12 87.5 1000 1087.5 0.546 593.74 Total 1314.00 The return from the above calculations comes out as 5.17%. Hence, if the rate of return is 5.17%, then the investor would be indifferent to investment in the given bond. Required return calculation for preference shares Current market price of preference price = $ 25.5 Annual dividend on preference share = $ 2.5 Actual return on preference share = (2.5/25.50)*100 = 9.8% pa Hence, if the rate of return is 9.8%, then the investor would be indifferent to investment in the given preference share. Required return calculation for shares Current market price of share = $ 36.75 Growth rate in EPS = (3.06/1.49)(1/5) -1 = 15.48% Dividend to be paid next year = 1.32*(1.1548) = $ 1.524 36.75 = 1.524/(x-0.1548) Solving the above, we get, x = 19.63% pa Hence, if the rate of return is 19.63%, then the investor would be indifferent to investment in the given share. References Brealey, R., Myers, S.and Allen, F. (2008), Principles of Corporate Finance (Global edition), New York: McGraw Hill PublicationsDamodaran, A. (2008), Corporate Finance, London: Wiley Publications Parrino, R. and Kidwell, D. (2011), Fundamentals of Corporate Finance, London: Wiley Publications Petty, J.W., Titman, S., Keown, A.J., Martin, P., Martin J.D. Burrow, M. (2015), Financial Management: Principles and Applications, Sydney: Pearson Australia