Question 1
Equity securities can be termed as the financial securities that represent the part of the corporation and the most common form of the equity security is the common stock. Equity security is different from the other securities in the terms of ownership. The equity security holder becomes the part of the investment and the securities are of similar nature.
Equity security is flexible and the shareholders are going to earn on the basis of the potential earnings which are of unlimited nature. With the potential earnings comes the factor of the risk as well. The company in case of liquidation are entitled to pay back to the debt holders first rather than the equity holders (Ilchenko, 2014).
Debt securities on the other hand are a type of the financial asset which the company is required to pay back in the terms of fixed installments. For example corporate bonds are the type of the debt securities and the investors lend their money to the corporation for a pre-established number of interest payments. Government bonds, on the other hand, are debt securities issued by governments and sold to investors. Investors lend money to the government in return for interest payments and a return of their principal upon the bond’s maturity (Geronimo, 2019).
Question 2
A bond’s yield can be expressed as the effective rate of return based on the actual market value of the bond. A yield is a function of the price, and it changes over the time period as it has a direct relationship with change in the interest rates, demand for the instrument, time to maturity and credit quality of a particular bond (Belke, Dubova and Volz, 2018). Yield is a figure showing the return getting on a bond where bond’s yield is defined as the discount rate linking with the cash flows of bond to its current dollar price. It can be expressed as an annual percentage where it is affecting a large part in terms of the price paid by the buyer. It is derived as dividing its coupon payment by the bond’s face value. High-quality bonds are considered as safe investment where it is important to understand the way bond yields and prices work.
A coupon rate is the annual amount of interest which will be received by the owner or the holder of the bond. A bond investor is more likely to base a decision on the basis of the coupon rate only. The coupon rate is static when the bonds are issued from the side of the government. Moreover, a bond is considered as a strong investor confidence indicator within the market and in the government. It is used for funding projects and expansions, or tiding over budgetary deficits considered to be safer than equities. Bond yields is defined as an economic indicator as well where the economy of any country include growth rate, inflation, national income, and lending rate of the central bank.
Question 3
Systematic risk is an inherent risk existing in the stock market and this type of risk is applicable to all the sectors. If any flow of event or the information results in the impact of the stock market, a consistent reaction will flow. If the number of shares is increased in a specified portfolio and this is largely due to changes in the macroeconomics level (Vakulchyk and Protasova, 2017).
Unsystematic risk on the other hand is the risk which is also termed as the specific risk or diversifiable risk. These are the risks and are of unplanned nature and can also cause widespread disruption. This type of risk is peculiar to an asset, a risk that can be eliminated by diversification (Waemustafa and Sukri, 2016).
Question 4
CAPM model offers a theoretical approach that looks into the financial markets which allows the investors to cover the expected returns. The investor focuses on the market price of the securities as the market premium is one of the important features that are used while applying CAPM model. This model describes the relationship among the expected return for assets and systematic risk, mainly stocks. It is broadly used within the finance in terms of pricing risk securities and generating expected returns for assets mentioned the risk of cot of capital and those assets. It also provides a useful measure in terms of helping investors determining the kind of investment return deserved. Moreover, it is stress-tested and easily calculated in relation to unrealistic assumptions for providing useful outcome in several situations. Lastly, its assumptions regarding risk result in investors holding diversified portfolios for minimizing risk.
Question
A)
The assumptions underlying the use of dividend growth model for the estimation of a company’s cost of equity.
B)
The market value proportions of the debt, preference shares and ordinary equity comprising the capital structure have been determined below.
| Weights | Amount | Weights |
| Debt | 3000000 | 27% |
| Preference shares (1000000*2.5) | 2500000 | 22% |
| Equity (6000000*.95) | 5700000 | 51% |
| 11200000 | 100% |
C)
After tax cost of capital of each source of finance has been determined below.
| Calculation of cost of debt | Amount |
| Semiannually cost of debt before tax | 8.50% |
| Cost of debt after tax rate | 5.95% |
| Calculation of cost of equity | Amount |
| Expected dividend | 5.35 |
| Growth rate | 7% |
| Share Price | 0.95 |
| Cost of equity | 0.95*-7% = 5.35 |
| Cost of equity | 13.00% |
| Cost of preference shares | Amount |
| Dividend (1000000*.38) | 380000 |
| Market Price of preference share | 2500000 |
| Cost of preference shares | 15.2% |
D)
Determination of after tax weighted average cost of capital
| WACC | Cost | Weights | Workings |
| COST OF EQUITY | 13.00% | 51% | 6.616% |
| COST OF DEBT | 5.95% | 27% | 1.594% |
| COST OF PREFERENCE SHARES | 15.2% | 22% | 3.393% |
| 11.603% |
E)
The conditions can firm’s the weighted average cost of capital can be used for assessing the new project. A company will mostly use its WACC as a hurdle rate for the purpose of selection of the proposal as well as for financial modeling of internal investments. If the company has an investment opportunity has a lower Internal Rate of Return than its WACC, it should buy back its own shares or pay out a dividend instead of investing in the project (Linnenluecke, Smith, Shen, Zhu and Liang, 2020).
F)
From the overall analysis it can be said that proposal having a payback period of 3.84 years as the company will be able to recover the cost in 3.84 years and this is a feasible option as the cost can be recovered in a subtle way.
Question 3
The internal rate of return of the project is 12% and this is acceptable as the company requires the return on investment of 12%.
| Project | Cash flows |
| 0 | $ (74,515.00) |
| 1 | $ 15,000.00 |
| 2 | $ 15,000.00 |
| 3 | $ 15,000.00 |
| 4 | $ 15,000.00 |
| 5 | $ 15,000.00 |
| 6 | $ 15,000.00 |
| 7 | $ 15,000.00 |
| 8 | $ 15,000.00 |
| IRR | 12.0% |
If the company wants to have an IRR of 15% than the annual net cash flows shall be continued for two more years and in total for ten years.
With the given project life of 8 years, the minimum annual net cash flows that shall be minimum is $10000 and beyond and less than this the net cash flows will be negative.
Observations
A)
The prices of the two bonds namely Bond P and Bond Q are as follows when the rate of interest is 7.5%.
| Treasury Bonds | ||
| Bond P | ||
| When YTM IS 10 % | ||
| Particulars | ||
| Coupon (10%/2) | 5% | |
| YTM | 8% | |
| Maturity (4*2) | 8.00 | |
| Par value | 1000.00 | Assumed |
| Particulars | WORKINGS | |
| Coupon | 50 | (1000*2%) |
| (1 + YTM )^N | 5% | |
| P | 1000 | |
| Bond price | $ 1,311.71 | |
| Bond Q | ||
| When YTM IS 10 % | ||
| Particulars | ||
| Coupon (8%/4) | 4% | |
| YTM | 8% | |
| Maturity (8*2) | 16.00 | |
| Par value | 1000.00 | Assumed |
| Particulars | ||
| Coupon | 40 | |
| (1 + YTM )^N | 5% | |
| P | 1000 | |
| Bond price | $ 3,122.01 |
The bond price of P is $1311 and Bond Q is $3122.
B)
The prices of the two bonds namely Bond P and Bond Q are as follows when the rate of interest is 12%.
| Treasury Bonds | ||
| Bond P | ||
| When YTM IS 10 % | ||
| Particulars | ||
| Coupon (10%/2) | 5% | |
| YTM | 12% | |
| Maturity (4*2) | 8.00 | |
| Par value | 1000.00 | Assumed |
| Particulars | WORKINGS | |
| Coupon | 50 | (1000*2%) |
| (1 + YTM )^N | 5% | |
| P | 1000 | |
| Bond price | $ 1,262.01 | |
| Bond Q | ||
| When YTM IS 10 % | ||
| Particulars | ||
| Coupon (8%/4) | 4% | |
| YTM | 12% | |
| Maturity (8*2) | 16.00 | |
| Par value | 1000.00 | Assumed |
| Particulars | ||
| Coupon | 40 | |
| (1 + YTM )^N | 5% | |
| P | 1000 | |
| Bond price | $ 2,897.09 |
The bond price of P is $1262 and Bond Q is $2897.
C)
The observations that can be understood from the overall calculations are that bond price fluctuates when there is an increase in the yield to maturity rates. As it can be observed the bond price of P was $1311 and that of the Bond Q is $3122 when YTM is 7.5% and as the YTM increased to 12%, the bond price shifted to $1262 and in case of Bond Q the bond price is $2897. This typically reflects that as a when the YTM increases the bond price reduces and this also inhibits the inverse relationship between the price and the yield to maturity.
References
Belke, A., Dubova, I. and Volz, U., 2018. Bond yield spillovers from major advanced economies to emerging Asia. Pacific Economic Review, 23(1), pp.109-126.
Geronimo, R.S.Q., 2019. Hybrid Securities and the Debt-Equity Classification Problem. Phil. LJ, 92, p.29.
Ilchenko, M., (2014) SECURITIES: DEBT SECURITIES. Knowledge Transfer in the Global Academic Environment: Publication in 3 volumes., p.104.
Linnenluecke, M.K., Smith, T., Shen, Y., Zhu, Y. and Liang, Z., 2020. What Does the CAPM Say About Operating Leverage?. Abacus, 56(2), pp.288-291.
Recchioni, M.C. and Tedeschi, G., 2017. From bond yield to macroeconomic instability: A parsimonious affine model. European Journal of Operational Research, 262(3), pp.1116-1135.
Vakulchyk, O. and Protasova, Y., 2017. Unsystematic Risk and Enterprise Investment Attractiveness. In Advanced Engineering Forum (Vol. 22, pp. 107-111). Trans Tech Publications Ltd.
Waemustafa, W. and Sukri, S., 2016. Systematic and unsystematic risk determinants of liquidity risk between Islamic and conventional banks. International Journal of Economics and Financial Issues, 6(4), pp.1321-1327.
Question 1
Equity securities can be termed as the financial securities that represent the part of the corporation and the most common form of the equity security is the common stock. Equity security is different from the other securities in the terms of ownership. The equity security holder becomes the part of the investment and the securities are of similar nature.
Equity security is flexible and the shareholders are going to earn on the basis of the potential earnings which are of unlimited nature. With the potential earnings comes the factor of the risk as well. The company in case of liquidation are entitled to pay back to the debt holders first rather than the equity holders (Ilchenko, 2014).
Debt securities on the other hand are a type of the financial asset which the company is required to pay back in the terms of fixed installments. For example corporate bonds are the type of the debt securities and the investors lend their money to the corporation for a pre-established number of interest payments. Government bonds, on the other hand, are debt securities issued by governments and sold to investors. Investors lend money to the government in return for interest payments and a return of their principal upon the bond’s maturity (Geronimo, 2019).
Question 2
A bond’s yield can be expressed as the effective rate of return based on the actual market value of the bond. A yield is a function of the price, and it changes over the time period as it has a direct relationship with change in the interest rates, demand for the instrument, time to maturity and credit quality of a particular bond (Belke, Dubova and Volz, 2018). Yield is a figure showing the return getting on a bond where bond’s yield is defined as the discount rate linking with the cash flows of bond to its current dollar price. It can be expressed as an annual percentage where it is affecting a large part in terms of the price paid by the buyer. It is derived as dividing its coupon payment by the bond’s face value. High-quality bonds are considered as safe investment where it is important to understand the way bond yields and prices work.
A coupon rate is the annual amount of interest which will be received by the owner or the holder of the bond. A bond investor is more likely to base a decision on the basis of the coupon rate only. The coupon rate is static when the bonds are issued from the side of the government. Moreover, a bond is considered as a strong investor confidence indicator within the market and in the government. It is used for funding projects and expansions, or tiding over budgetary deficits considered to be safer than equities. Bond yields is defined as an economic indicator as well where the economy of any country include growth rate, inflation, national income, and lending rate of the central bank.
Question 3
Systematic risk is an inherent risk existing in the stock market and this type of risk is applicable to all the sectors. If any flow of event or the information results in the impact of the stock market, a consistent reaction will flow. If the number of shares is increased in a specified portfolio and this is largely due to changes in the macroeconomics level (Vakulchyk and Protasova, 2017).
Unsystematic risk on the other hand is the risk which is also termed as the specific risk or diversifiable risk. These are the risks and are of unplanned nature and can also cause widespread disruption. This type of risk is peculiar to an asset, a risk that can be eliminated by diversification (Waemustafa and Sukri, 2016).
Question 4
CAPM model offers a theoretical approach that looks into the financial markets which allows the investors to cover the expected returns. The investor focuses on the market price of the securities as the market premium is one of the important features that are used while applying CAPM model. This model describes the relationship among the expected return for assets and systematic risk, mainly stocks. It is broadly used within the finance in terms of pricing risk securities and generating expected returns for assets mentioned the risk of cot of capital and those assets. It also provides a useful measure in terms of helping investors determining the kind of investment return deserved. Moreover, it is stress-tested and easily calculated in relation to unrealistic assumptions for providing useful outcome in several situations. Lastly, its assumptions regarding risk result in investors holding diversified portfolios for minimizing risk.
Question
A)
The assumptions underlying the use of dividend growth model for the estimation of a company’s cost of equity.
B)
The market value proportions of the debt, preference shares and ordinary equity comprising the capital structure have been determined below.
| Weights | Amount | Weights |
| Debt | 3000000 | 27% |
| Preference shares (1000000*2.5) | 2500000 | 22% |
| Equity (6000000*.95) | 5700000 | 51% |
| 11200000 | 100% |
C)
After tax cost of capital of each source of finance has been determined below.
| Calculation of cost of debt | Amount |
| Semiannually cost of debt before tax | 8.50% |
| Cost of debt after tax rate | 5.95% |
| Calculation of cost of equity | Amount |
| Expected dividend | 5.35 |
| Growth rate | 7% |
| Share Price | 0.95 |
| Cost of equity | 0.95*-7% = 5.35 |
| Cost of equity | 13.00% |
| Cost of preference shares | Amount |
| Dividend (1000000*.38) | 380000 |
| Market Price of preference share | 2500000 |
| Cost of preference shares | 15.2% |
D)
Determination of after tax weighted average cost of capital
| WACC | Cost | Weights | Workings |
| COST OF EQUITY | 13.00% | 51% | 6.616% |
| COST OF DEBT | 5.95% | 27% | 1.594% |
| COST OF PREFERENCE SHARES | 15.2% | 22% | 3.393% |
| 11.603% |
E)
The conditions can firm’s the weighted average cost of capital can be used for assessing the new project. A company will mostly use its WACC as a hurdle rate for the purpose of selection of the proposal as well as for financial modeling of internal investments. If the company has an investment opportunity has a lower Internal Rate of Return than its WACC, it should buy back its own shares or pay out a dividend instead of investing in the project (Linnenluecke, Smith, Shen, Zhu and Liang, 2020).
F)
From the overall analysis it can be said that proposal having a payback period of 3.84 years as the company will be able to recover the cost in 3.84 years and this is a feasible option as the cost can be recovered in a subtle way.
Question 3
The internal rate of return of the project is 12% and this is acceptable as the company requires the return on investment of 12%.
| Project | Cash flows |
| 0 | $ (74,515.00) |
| 1 | $ 15,000.00 |
| 2 | $ 15,000.00 |
| 3 | $ 15,000.00 |
| 4 | $ 15,000.00 |
| 5 | $ 15,000.00 |
| 6 | $ 15,000.00 |
| 7 | $ 15,000.00 |
| 8 | $ 15,000.00 |
| IRR | 12.0% |
If the company wants to have an IRR of 15% than the annual net cash flows shall be continued for two more years and in total for ten years.
With the given project life of 8 years, the minimum annual net cash flows that shall be minimum is $10000 and beyond and less than this the net cash flows will be negative.
Observations
A)
The prices of the two bonds namely Bond P and Bond Q are as follows when the rate of interest is 7.5%.
| Treasury Bonds | ||
| Bond P | ||
| When YTM IS 10 % | ||
| Particulars | ||
| Coupon (10%/2) | 5% | |
| YTM | 8% | |
| Maturity (4*2) | 8.00 | |
| Par value | 1000.00 | Assumed |
| Particulars | WORKINGS | |
| Coupon | 50 | (1000*2%) |
| (1 + YTM )^N | 5% | |
| P | 1000 | |
| Bond price | $ 1,311.71 | |
| Bond Q | ||
| When YTM IS 10 % | ||
| Particulars | ||
| Coupon (8%/4) | 4% | |
| YTM | 8% | |
| Maturity (8*2) | 16.00 | |
| Par value | 1000.00 | Assumed |
| Particulars | ||
| Coupon | 40 | |
| (1 + YTM )^N | 5% | |
| P | 1000 | |
| Bond price | $ 3,122.01 |
The bond price of P is $1311 and Bond Q is $3122.
B)
The prices of the two bonds namely Bond P and Bond Q are as follows when the rate of interest is 12%.
| Treasury Bonds | ||
| Bond P | ||
| When YTM IS 10 % | ||
| Particulars | ||
| Coupon (10%/2) | 5% | |
| YTM | 12% | |
| Maturity (4*2) | 8.00 | |
| Par value | 1000.00 | Assumed |
| Particulars | WORKINGS | |
| Coupon | 50 | (1000*2%) |
| (1 + YTM )^N | 5% | |
| P | 1000 | |
| Bond price | $ 1,262.01 | |
| Bond Q | ||
| When YTM IS 10 % | ||
| Particulars | ||
| Coupon (8%/4) | 4% | |
| YTM | 12% | |
| Maturity (8*2) | 16.00 | |
| Par value | 1000.00 | Assumed |
| Particulars | ||
| Coupon | 40 | |
| (1 + YTM )^N | 5% | |
| P | 1000 | |
| Bond price | $ 2,897.09 |
The bond price of P is $1262 and Bond Q is $2897.
C)
The observations that can be understood from the overall calculations are that bond price fluctuates when there is an increase in the yield to maturity rates. As it can be observed the bond price of P was $1311 and that of the Bond Q is $3122 when YTM is 7.5% and as the YTM increased to 12%, the bond price shifted to $1262 and in case of Bond Q the bond price is $2897. This typically reflects that as a when the YTM increases the bond price reduces and this also inhibits the inverse relationship between the price and the yield to maturity.
References
Belke, A., Dubova, I. and Volz, U., 2018. Bond yield spillovers from major advanced economies to emerging Asia. Pacific Economic Review, 23(1), pp.109-126.
Geronimo, R.S.Q., 2019. Hybrid Securities and the Debt-Equity Classification Problem. Phil. LJ, 92, p.29.
Ilchenko, M., (2014) SECURITIES: DEBT SECURITIES. Knowledge Transfer in the Global Academic Environment: Publication in 3 volumes., p.104.
Linnenluecke, M.K., Smith, T., Shen, Y., Zhu, Y. and Liang, Z., 2020. What Does the CAPM Say About Operating Leverage?. Abacus, 56(2), pp.288-291.
Recchioni, M.C. and Tedeschi, G., 2017. From bond yield to macroeconomic instability: A parsimonious affine model. European Journal of Operational Research, 262(3), pp.1116-1135.
Vakulchyk, O. and Protasova, Y., 2017. Unsystematic Risk and Enterprise Investment Attractiveness. In Advanced Engineering Forum (Vol. 22, pp. 107-111). Trans Tech Publications Ltd.
Waemustafa, W. and Sukri, S., 2016. Systematic and unsystematic risk determinants of liquidity risk between Islamic and conventional banks. International Journal of Economics and Financial Issues, 6(4), pp.1321-1327.
