Module- Case: STOCKS AND BONDS
Case Assignment
Stock Valuation
Mr. Hillbrandt is impressed with your ability to explain financial concepts so he asks for help with learning about stock valuation. Mr. Hillbrandt really liked the examples you provided last time (module 1), so it seems as if you need to sit down and create some relevant examples for this topic too. Below is some information that helps you brush up on the topic.
Read this article related to the intrinsic value of stock, paying special attention to the section entitled "Constant Growth Model":
Alvarez, S. (2015). What is the intrinsic value of stock? Investopedia.
Now, let's work the following problem:
A company just paid an annual dividend of $2.00 per share. Dividends are anticipated to grow at a rate of 8% per year forever. The stock's beta is 1.5, the risk-free rate is 2.5%, and the expected return on the overall stock market is 7.5%. What's the intrinsic value of the company's common stock?
Using the formula:
Stock Price = D1 ÷ (k - g)
Where:
D1 = dividend for the coming year
k = required rate of return (NOTE: k must be greater than g)
g = growth rate of dividends
(Note: Decimals and not percentages must be used for the model to work)
1) To calculate the dividend for the coming year, we need to multiply the last dividend by the expected dividend growth rate. And so:
D1 = $2.00 x 1.08 = $2.16
2) Find the Market risk premium using the following formula:
Market risk premium = Expected return on stock - Risk free rate
= 7.5% - 2.5%
= 5%
3) Then, to find k, or the required rate of return, use the following formula:
k = risk free rate + [market risk premium x beta]
= 2.5% + (5% * 1.5)
= 10%
4) g = 8% (or 0.08) growth rate of dividends
5) Stock Price = D1 ÷ (k - g)
= $2.16 ÷ (.10 - .08)
= $2.16 ÷ .02
= $108.00 (ANSWER)
5) Check your answer with this online calculator: https://www.zenwealth.com/businessfinanceonline/SV/CGStockCalculator.html
Now, work the following problems:
1. A company just paid an annual dividend of $3.25 per share. Dividends are anticipated to grow at a rate of 5% per year forever. The stock's beta is 1.2, the risk-free rate is 3.5%, and the expected return on the overall stock market is 5.5%. What's the intrinsic value of the company's common stock? ANSWER = $379.17
2. A company just paid an annual dividend of $2.35 per share. Dividends are anticipated to grow at a rate of 6.25% per year forever. The stock's beta is 1.6, the risk-free rate is 4.25%, and the expected return on the overall stock market is 8.5%. What's the intrinsic value of the company's common stock? ANSWER = $51.48
Required:
Part I consists of three questions.
Do the computations for the example below. Show the computations step by step, so Mr. Hillbrandt can easily follow your examples.
1. The company's common stock dividends are anticipated to grow at a constant 5.5% growth rate per year going forward. The company just paid an annual dividend (that is, D-zero) of $3 per share. What's the intrinsic value of the stock based on the following required rates of return?
1. 6%
2. 8%
3. 10%
4. 12%
2. If the stock is currently selling for $40 per share, is the stock a good buy? Interpret the results and justify your decision.
3. The company just paid an annual dividend of $1.50 per share. Dividends are anticipated to grow at a stable rate of 10% per year forever. The stock's beta is 1.2, the risk-free rate is 4%, and the expected return on the overall stock market is 11%. What is the intrinsic value of the company's common stock?
Part II
Select one company that is a member of the Dow Jones Industrial Average.
Apply the Dividend Discount Model and justify why you think that the stock is currently undervalued, overvalued, or fully valued. Please be sure to state your assumptions and justify your results. What is the relationship, if any, between stockholders' wealth and financial decisions?
Computations (use Excel).
Use Excel to make the part I and II computations. Make sure you separate the two parts and organize the information, so Mr. Hillbrandt easily understands.
Memo (use Word).
Explain the concept and computations in part I to the CEO. Start with an introduction and end with a conclusion. Each of the four or five paragraphs should have a heading.
Short Essay - Part II (use Word).
Let's look at this issue from an investor's perspective and respond to the question above. Do research as needed and respond to the questions posed in part II.
Start with an introduction and end with a summary or conclusion. Use headings. Don't forget to reference your sources. Maximum length of two pages.
Assignment Expectations
Each submission should include two files: (1) An Excel file; and (2) A Word document. The Word document shows the memo first and short essay last. Assume a knowledgeable business audience and use required format and length. Individuals in business are busy and want information presented in an organized and concise manner.
Module- SLP: STOCKS AND BONDS
Bond Valuation
This assignment contains two parts: Part I and Part II.
Part I
Answer these questions and show your work:
• Assume that the company that you selected for the Module 1 SLP has a bond outstanding that matures in 20 years and has a coupon rate of 6.5%. The par value of the bond is $1,000.
• If the yield to maturity is 8% and the bond pays interest on an annual basis, what's the current price of the bond? Is the bond selling for a premium or discount? How can you tell?
• If the yield to maturity is 8% but the bond pays interest on a semi-annual basis instead of an annual basis, what's the current price of the bond? Is it different from the value when using annual compounding? Explain.
• Now, assume that the economy enters into a recession and interest rates fall. The bond's yield to maturity is now 5%. What's the bond's new price? How does the price compare with your answer in part a? Why did the bond's value change?
• A bond matures in ten years and is currently selling for $1,125. The bond pay interest annually, has a par value of $1,000, and a yield to maturity of 10.75%. What's the bond's current yield?
Part II:
Write a 2-page essay comparing reinvestment risk and interest rate risk and how an investor can protect his or her portfolio from those risks. Please be sure to discuss duration in your paper.
SLP Assignment Expectations
You are expected to:
• Describe the purpose of the report and provide a conclusion. An introduction and a conclusion are important because many busy individuals in the business environment may only read the first and the last paragraph. If those paragraphs are not interesting, they never read the body of the paper.
• Answer the SLP Assignment question(s) clearly and provide necessary details.
• Write clearly and correctly-that is, no poor sentence structure, no spelling and grammar mistakes, and no run-on sentences.
• Provide citations to support your argument and references on a separate page. (All the sources that you listed in the references section must be cited in the paper.) Use APA format to provide citations and references.
• Type and double-space the paper
Whenever appropriate, please use Excel to show supporting computations in an appendix, present financial information in tables, and use the data computed to answer follow-up questions. In finance, in addition to being able to write well, it's important to present information in a professional manner and to analyze financial information. This is part of the assignment expectations and will be considered for grading purposes.