In this assignment, you are expected to:
- Compute and interpret financial ratios
- Evaluate investment proposals
- Apply knowledge to decide appropriate financing plan and dividend policy
In June 2015, you joined a private banking firm as a relationship manager. As your first assignment, your boss asked you to join her for a client meeting with Mr. Chou. During your discussion with client, you understand that Mr. Chou retired at the age of 65 years this year and has recently sold his software business for $2 million. He intends to retire and hopes to invest the proceeds in income generating financial assets.
Since he will be retiring, he would need an investment that pays periodic payments. He is considering investment in stocks, bonds or annuity. You have identified the following possible investments: Equity stock of Commodity Investment Company which invests in commodities.
At your request, your firm's equity research department furnished you with their 5-year dividend forecast for this counter:
|
Year
|
Dividend Per Share (Cents)
|
|
2019
|
13
|
|
2018
|
12
|
|
2017
|
11
|
|
2016
|
11
|
|
2015
|
10
|
The dividends are anticipated to grow at 3% per annum from 2020 onwards. They also told you that the market risk premium is 4% and the risk-free rate is 2%. The beta and standard deviation of this company are 1.1 and 30% respectively. The shares are trading at $3.25 on June 30, 2015. The dividends will be paid on 31 December every year.
Your suggestion for him to consider bonds issued by OSIM international and the salient terms are detailed as follows:
- Issue date = July 1, 2011
- Amount issued = $850 million
- Maturity date = June 30, 2021
- Coupon = 8%
- Payment = Semi-annual
- Par value = $100.00
OSIM received an Aa2 credit rating by Moody's and the credit spread for corporate bonds with similar rating is 4%. The standard deviation of this bond is 12% and the correlation coefficient between stock and bonds is -0.3.
The third option is to purchase a life annuity offered by insurance company. This annuity scheme will make a payout of $2,500 at the end of each month for as long as policyholder lives. Mr. Chua expects his life expectancy to be that of an average Singaporean, which is 85 years.
You will be having a follow up meeting with Mr. Chou next week and your boss needs you to address the issues raised at the last meeting as well as evaluate the risk and return of a portfolio comprising stock and bond in the following combinations:
|
stock
|
bond
|
|
100%
|
0%
|
|
80%
|
20%
|
|
60%
|
40%
|
|
40%
|
60%
|
|
20%
|
80%
|
|
0%
|
100%
|
Question 1 Calculate the cost of equity by applying the Capital Asset Pricing Model (CAPM).
Question 2 Calculate the net present value of dividends paid by the company and advise Mr.Chou whether he should consider investing in this stock. Note that the price is being calculated as of June 30 while dividends are paid on December 31 every year.
Question 3 Apply principle of time value of money to calculate the fair market value of the bond.
Question 4 Calculate the value of the life annuity offered by the insurance company. Assume the interest rate for annuities to be 3%.
Question 5 Calculate the expected return and standard deviation of the two-asset portfolio and plot a graph to illustrate the data points. Assume the expected return on stock and bond are 10% and 6% respectively.
Recommend a portfolio mix to Mr.Chou on the presumption that he is a risk adverse investor.