Question

Simone is considering to move funds from money market account to capital market. Her broker recommends three investments.

Investment 1: Corporate Bond A
It has a face value of $100,000 with a 5.75% p.a. coupon rate. Coupon is paid semi-annually. The bond will mature in five years. Yield-to-maturity (YTM) is 6.5% p.a.

Investment 2: Preference Share B
It has a face value of $100 with a 10% p.a. preference dividend rate. Cost of equity is 9% p.a.

Investment 3: Common Share C
It pays annual dividends and a $4 dividend was paid yesterday. As per the market consensus, the company’s dividend is expected to decrease by 5% per annum in the first three years, then grow by 20% for next two years. After that, the dividend growth rate will become 5% p.a. constant till foreseeable future. Cost of equity is 15% p.a.

a. If their market prices are shown in the below table, which investment(s) do you suggest Simone should buy? | Investment Market Price Corporate Bond A $97,241.16 Preference Share B | Common Share C | 109.84 37.98

Answer 1

Ans. Analysing Corporate Bond A-

Equilibrium Price = 2875 x PVIAf(2.875%,10) + 100,000 x PVIf(2.875%,10) = $ 99,269.85

Since the market price of Corporate Bond is less than its equilibrium price Simone should invest in Corporate Bond A.

Analysing Preference Shares B-

Equilibrium Price = [100 + (100 x 0.1)] / 1.09 = $ 100.92

Since the market price of Preference Share is more than its equilibrium price Simone should not invest in Preference Share B.

Analysing Common Share C-

Year	Dividend	PV of Div
1	$3.8	$3.30
2	$3.61	$2.73
3	$4.33	$2.85
4	$5.20	$2.97
5	$6.24	$3.10
Total		$14.96

TV at year 6 = [6.24 x (1.05)] / 0.15 - 0.05 = $65.52

PV of Common Share C = ($65.52 x 0.4972) + $14.96 = $47.54

Since the market price of Common Share is less than its equilibrium price Simone should invest in Common Share C.