Question
a Kangaroo Ltd and Wombat Ltd operate in the same industry and you reason that their discount rates are similar, approximately 8%. Kangaroo Ltd has a share price of $5.00, and is forecasted to pay a dividend of 20 cents per share next year. Wombat Ltd has a share price of $8.50, and is forecast to pay a dividend of 17 cents per share next year. What are the growth rates of the two stocks? Why is Wombat Ltd trading at a higher price even though it pays a smaller dividend?
b Two Government bonds A and B have a face value of $100 000 and pay coupons at the rate of 10% annually. Bond A has four years to maturity and bond B has eight years to maturity.
i If the interest rate rises to 12% p.a., what are the prices of the two bonds?
ii If the current interest rate is 7.5% p.a., what are the prices of the two bonds?
iii What observations in relation to the interest rate risk of investing in bonds can be made given the above results?