First you are required to analyze your bond as demonstrated in B&E, the Mini Case on pp.230-231, and your stock as shown in the Mini Case of chapter 7 on pp.322-323. Then compare the performance of your stock with your bond and also benchmark your bond against a similar Treasury Bond of a similar maturity. Use the Bloomberg system to obtain the necessary data for each the last five years
Analyze and evaluate the above instruments and deliver a written final report evaluating your company. Reporting and presentation of results will be in accord with Global Investment Performance Standards (GIPS) but also give due consideration to Accounting Standards.
The study of the assignment shed light on the various sections of the stocks and bonds of a company. The reader will be able to understand the exact relation of the stock and bonds of any company along with the importance of evaluating the industry benchmark. . Moreover, the free cash flow valuation model has been presented in a different number of ways with massive relation with the various accounting information that is obtained from the evaluations.
Par value- It is amount the bondholder receives when the bond matures. In addition, the newly issued bonds are sold at par value (Hu, Schwabe & Li, 2015). When the bond is sold above the trade price, it is said that the bond is sold at premium.
Coupon- The coupon is the interest rate the bondholder receives as interest (Racic, 2015). It is operated electronically nowadays because physical evidence is not required to be maintained. The marketing for the bonds are done online and it is very convenient for the bondholders as well.
Maturity- It is the date ascertained in which the bondholders receives the maturity amount with certain rate of interest upon the invested amount (Palaiodimos & Tzavalis, 2015). It is given upon the principal and the time duration of the bond.
Call provision: It is the provision of the bond in which the issuer is favored over the bondholder. In this case, the bondholder receives a fixed income upon the bond hold by them (Lagoarde-Segot, 2015). When there is a call for the bond by the issuer, the bondholder have to retire the bond and get the particular value of the bond upon the principal paid with any relevant interest.
Sinking Fund Provision: Sinking fund is the repaying fund that is borrowed through the issue of a bond. In this case, the issuer makes periodic payments to the company who has bought a part of the bond, issued in the market (Hu, Schwabe & Li, 2015).
The above two provisions make the bond more risky.
One can determine the value of any asset by expecting the rate of face value ascertained during the time of the investment. It is difficult to estimate the value as in the case of future cash flow but it is possible by going through the past returns received by the investor. The estimated rate as per the rate of inflation in the market shall assist the investor to determine the value of investment accordingly (Fairhurst, 2015).
The price of a bond is determined by using discount rate in order to calculate the expected cash flow to the present value of the bond. There are several influences that effects the price of the bond are credit ratings, demand and age to maturity of the bond (Andrikopoulos & Economou, 2015). In addition, the demand and supply of the bond is a significant factor upon which the value of the bond is dependent.
Calculation of value of bond:
PVA = I[1-(1+k)ˆ-n]/k
|
Face value |
$1,000 |
|
|
Annual coupon rate |
10% |
|
|
Annual Return rate |
10% |
|
|
Years to maturity |
10 |
|
|
Frequency of payment |
10 |
|
|
Value of Bond |
($1,000.00) |
|
If the rate of returns hike with 3% due to inflation, then the return rate will be 13%. The calculated table below can ascertain the effect of inflation:
|
Face value |
$1,000 |
|
|
Annual coupon rate |
10% |
|
|
Annual Return rate |
13% |
|
|
Years to maturity |
10 |
|
|
Frequency of payment |
10 |
|
|
Value of Bond |
($832.65) |
|
As per the assessment of above table, it is seen that we now have discounted bond as per the value of bond calculated with the change of rate of return (Andrikopoulos, 2015).
When the inflation fell and the rate of return declined to 7%, then the bond’s value is ascertained below:
|
Face value |
$1,000 |
|
|
Annual coupon rate |
10% |
|
|
Annual Return rate |
7% |
|
|
Years to maturity |
10 |
|
|
Frequency of payment |
10 |
|
|
Value of Bond |
($1,215.23) |
|
As per the ascertainment of the above table, it is seen that the bonds are available at premium due to increased value and decreased inflation rate (Yang & Zhao, 2015).
Comparing the condition of the bond, when there was inflation and when there was fall in inflation.
|
Face value |
$1,000 |
Face value |
$1,000 |
|
|
Annual coupon rate |
10% |
Annual coupon rate |
10% |
|
|
Annual Return rate |
13% |
Annual Return rate |
7% |
|
|
Years to maturity |
10 |
Years to maturity |
10 |
|
|
Frequency of payment |
10 |
Frequency of payment |
10 |
|
|
Value of Bond |
($832.65) |
Value of Bond |
($1,215.23) |
|
As per the situation of rise in inflation, the value of the bond decreases due to rise in the rate of return. On the other hand, the value of the bond increases when there is a fall in the inflation rate due to decrease in the rate of return given to the bondholders (Ruppert & Matteson, 2014).
Calculation of yield to maturity, when the selling price of the bond is $887, $1000 par value and return rate 9%.
|
Yield to Maturity |
||
|
Face Value |
$1,000 |
|
|
Annual rate of coupon |
10% |
|
|
Years of maturity |
10 |
|
|
Payment frequency |
10 |
|
|
Selling price of bond |
$887 |
|
|
Yield to maturity % |
0.12% |
Calculation of yield to maturity, when the selling price of the bond is $1134.20, $1000 par value and return rate 9%.
|
Yield to Maturity |
||
|
Face Value |
$1,000 |
|
|
Annual rate of coupon |
10% |
|
|
Years of maturity |
10 |
|
|
Payment frequency |
10 |
|
|
Selling price of bond |
$1,134 |
|
|
Yield to maturity % |
$0.08 |
As per the ascertainment of the above two table, the relation between the rate of return and coupon rate of bond have a great impact in the value of the bond. The rate of return if increased will have an adverse effect in the valuation of the bond and vice versa (Samonas, 2010). On the other hand, increase in the coupon rate will lead to increase in the value of bond proportionately and vice versa.
The total return, the capital gains for discounted bond and current yield is shown below in the table:
|
Yield to Maturity |
||||
|
Face Value |
$1,000 |
|||
|
Annual rate of coupon |
10% |
|||
|
Years of maturity |
10 |
|||
|
Payment frequency |
10 |
|||
|
Selling price of bond |
$887 |
|||
|
Yield to maturity % |
$0.12 |
|||
|
Current yield |
$0.11 |
|||
|
Total yield |
$0.23 |
|||
|
Capital gain for discount bond |
$113 |
When the payment made semiannually, the frequency of payment will get double due to partly payment made every year into two parts. Below table showed valuation calculated semiannually (Racic, 2015).
|
Face value |
$1,000 |
|
|
Annual coupon rate |
10% |
|
|
Annual Return rate |
13% |
|
|
Years to maturity |
10 |
|
|
Frequency of payment |
20 |
|
|
Value of Bond |
($832.39) |
|
|
Yield to Call |
||
|
Par Value |
$1,000 |
|
|
Year of maturity |
10 |
|
|
Frequency of payment |
20 |
|
|
Rate of coupon |
10% |
|
|
Maturity % |
8% |
|
|
Years to call |
5 |
|
|
Call off value |
$1,050 |
|
|
Selling price |
$1,135.90 |
|
|
Yield to Call |
$0.07 |
If this bond bought, then the possibility of yielding YTC will be more than YTM as the bond is valued more during the call only because the demand of the bond is more in the market (Palaiodimos & Tzavalis, 2015).
Real risk free rate of return is the return where there is no risk involved in the investment upon the bond (Racic, 2015).
Inflation premium is the increase in the returns due to hike in the rate of inflation in the economy (Lagoarde-Segot, 2015).
Default risk premium is the not received premium from the issuer to the bondholder (Iftikhar, 2015).
Liquidity premium is the premium in which the bond is exchanged in terms of currency.
Maturity Risk Premium is the risk involved when the bond reaches its maturity.
Nominal risk free rate is the rate in which the bondholders do not feel risk in buying the bond of which the demand is high in the market. The rate of return and coupon rate can be ascertained to estimate nominal risk free rate (Hu, Schwabe & Li, 2015).
Inflation premium can be estimated by ascertaining the demand and risk involved while purchasing the bond. Ascertaining the coupon rate can also provide an idea to the investor.
Bond spread is the instrument that shows the potential of investment in the bond. It is related to risk premium as it highlights the potential of the bondholder to peek over the previous investments upon the bond (Hoberg & Maksimovic, 2014). The bonds rating relates to the default risk because it includes the investment in the bond. The demand of the bond of the company and the company’s profitability affects the price of the bond. The amount of credit taken is another factor that emphasizes upon the rating of bond.
Price risk is the risk involving the risk restricted to the price of the bond. In the case 10-year bond have more rate risk as the rate fluctuates every year and 10 year is a long time to ascertain the returns of the bond (Grüber, 2013).
n. Reinvestment rate risk is the risk in which the reinvestment takes place at lower rate than the original investment done upon the bond (Fairhurst, 2015). 10-year bond will have more reinvestment rate risk as the investment may at premium depending upon the demand of the bond.
Reinvestment rate risk and interest rate risk are related to the maturity risk premium because the maturity value will be depending upon the value of reinvestment and coupon rate (Cadle et al., 2014).
p. Term structure refers to the fluctuating interest rates of bond that are for long term. Yield curve states the amount of interest yield from the investment in the bond.
Bankruptcy law states that if any company fails to pay the bonds then its company will be given noticed and seized if no action is taken upon the notice. If the firm is unable to pay the bond to the bank, then the company will be given months notice before liquefying it (Andrikopoulos, 2015). No, the bondholders would not be promised to pay all the promised payments as the situation lies of clearing the credit by the bondholders.
a). The common rights and privileges of the common stock holders are stated below:
b). 1. Formula to value any stock is the “General formula”, which is:
P= D1/(1+K)+ D2/(1+K)2+ D3/(1+K)3+….+Dn/(1+K)n
K: stands for required rate of return, which is:
the minimum return that you are willing to take when you invest in a stock.
D: stands for dividends, which are:
Payments made by a corporation to its shareholders members.
P: stands for the price or the value of the stock, which is:
Calculated by numerous formulas (Ex: general formula, N- period model, constant growth rate and infinite period model).
The stock whose dividends are accepted to rise at a stable tempo in the near future. This condition fits many recognized firms that tend to rise over the long run at the similar rate as the economy.
Constant growth stocks are valued as stated below:
P= D0 (1+g)/k-g
Moreover, it can be reduced by the below stated formula:
P= D1/k-g (LÃffler, & Kruschwitz, 2011)
P: stands for the price or the value of the stock, which is:-
D0: stands for the last dividend paid
D1: stands for the expected dividend in the future.
P= D1/k-g (Patterson, 2009)
Suppose k > g. if g > k, it will give a negative stock value. There are some cases where g experience huge expansion, which gives g > k and it cannot be forever the equation assumes that g is constant and will stay indefinitely, so, g cannot be more than k in the long – run.
c). Rate of return on the firm’s stock
k= RFR+ (Rm-RFR) β
= 7% + (5%-7%) 1.2
= 4.6%
RFR: Risk free rate .
Rm: Market risk premium.
β:The beta , which is:
Measure the sensitivity between stocks or portfolios and the market return, and the beta of the market is to 1 or the systematic risk is the risk that is affected by the market and it is uncontrollable.
Intrinsic price is the definite worth of a corporation and stock. It can be determined by the elementary scrutiny and is also known as fundamental value. However, it may different from its market value.
Formula:
P= D1/(k-g)
P: Price
D: dividend
K: required rate of return
P= 2.12/(0.13-0.06) = 30.2857$
2). Stock’s expected value after one year from now
After one year, the firm will reimburse the dividend to the stockholder and hence using d1 the expected value of the stock can be determined:
The same formula in the last question will be used:
P= D1/(k-g) where, P is Price, D is dividend and K is required rate of return
P= 2.2472/(0.13-0.06) = 32.10285714$
3). Expected yield of dividend, expected capital gains yield and the total return in the first year
Expected Dividend yield= D1/pt-1 (Pratt, 2012)
= 2.12/30.28
= 7%
Capital gain yield – This used to calculate return on a stock based on the appreciation of the stock.
Capital gain yield= pt-pt-1/pt-1
pt: stock price at time t.
pt-1: initial stock price.
Capital gain yield= 32.10-30.28/30.28
= 6%
Expected total return – The distinction amid capital gain yield and dividend yield calculates the total return on the stock.
Expected total return= 7%+6%=13%
e). If the stock prices of Temp’s force is selling at $ 30. 29, then the stock price is based more on the long – term expectations, which can be said by monitoring, the below stated evaluation:
P = D1 / (k-g)
Then,
K = (D1/p) + g
= (2.12/30.29) + 6%
= 13%
The necessary rate of return equal 13%
f). The stock market is volatile as a tightening in the economy have led to lower revenues for business. The impact on the estimated stock price if the g falls to 5% and rs changes to 12 % is given below:
^P1 = D2 / rs – g = $2.24 / (12 % – 5 %) = $32.00
h). Dividend yield and capital gained during the 1st year and expected in the fourth year
Calculation of the dividend of:
1st year:
DY=D1/P0
DY=2(1+0.30)/ 43.1419 = 0.060266= 6.0266 %
To calculate the Capital Gain Yield for year 1 we can choose one of two ways:
CGY= Expected Total Return – Dividend Yield (Soenen, 2013)
CGY= 0.13 – 0.060266 = 0.069734 = 6.9734%
4th year:
DY=D4/P0
DY= 2.3786 / 43.1419 = 0.05513 = 5.513%
Calculation of the Capital Gain Yield for year 4:
1- CGY= Pt-Pt-1/Pt-1
CGY= 0.13 – 0.05513 = 0.07487 = 7.487%
i). Free cash flow – The free cash flow (FCF) in corporate finance is defined to scrutinize what is accessible for sharing amid all the securities holders of a business entity (Streitferdt, 2009).
Weighted Average Cost of Capital (WACC) – The average outlay to a company of the finances that it has invested in the property of the firm is known as the Weighted Average Cost of Capital (WACC). This is collected of a probable amalgamation of retained earnings, preferred shares, and common shares debt.
Free cash – flow valuation model – The free cash flow valuation model can be presented in a different number of ways, which depends on the spectators and the accounting information that is obtainable. The free cash flow valuation model may differ from the net profits for a exact accounting phase as the free cash dispense takes into report the use of capital goods (Staubus, 2014).
j). Pie chart of company’s total value
The Efficient Market Hypothesis (EMH) states that stocks are constantly at equilibrium and an investor cannot hammer the marketplace
The shareholder right to the profit of a company after all various prior obligations that have been paid are equity claims. These are most important in the company’s liquidation and are also known as residual claims.
(1) Estimated Value of Operations =
= $24 Million (1 + 0.05) / (0.11 – 0.05) = 25.2 / 0.06 = $420 Million
(2) Estimated Total corporate value = Marketable Securities + Value of Operations. (Allman, 2010)
= $100 Million + $420 Million = $520 Million
(3) Estimated Intrinsic Value of Equity
The calculation of intrinsic value of equity is done on the basis of the net worth of the organization and the total number of paid up equity shares (Cornell, 2013).
Estimated Intrinsic Value of Equity = Total Net Worth of Company/ Total No of equity shares (Day, 2012).
Total Net Worth of Company = Marketable Securities + Debt + Preferred Stock (Thomas & Gup, 2010).
= $100 Million + $200 Million + $50 Million = $350 Million
Therefore, Estimated Intrinsic Value of Equity = ($350 Million/ 5 Million) = $70
(4) Estimated Intrinsic Stock Price per Share
Earnings per Share Average P/E Ratio
l.
(1) Horizon Value
|
Year |
1 Year |
2 Years |
3 Years |
|
Free Cash Flow |
-$10 Million |
$20 Million |
$35 Million |
Horizon Value = (Free Cash Flows for Year 3) / (Rate of return – Growth rate)
= $35 Million / (.11 – .05) = $583 Million
Value of Operations
= 36.75/ 0.06 = 612.5
(2) Estimated Intrinsic Value of Equity
Estimated Intrinsic Value of Equity = Total Net Worth of Company/ Total No of equity shares (Day, 2012).
= $35 Million/ 10 Million Shares = $3.5
In the study of commercial finance, free cash flow or FCF is the technique of looking at the cash course of the business of an organization for identifying the available elements for the purpose of distribution among all the securities holders within a corporate organization. This considered as useful for the parties including debt holders, equity holders, convertible security holders, preferred stock holders, when they need to experience how much cash is available and can be obtained from the company without causing any financial problems or issues for the daily operations.
The free cash flow can be estimated using various ways depending on the audience and the available accounting information (Kraft & Schwartz, 2010). In general, the meaning is taking the wages before taxes and interests add any depreciation and paying back, then subtract the changes within the capital expenditure and working capital. A number of adjustments or enhancement may also be done for eliminating and trying deformation based upon the intentions of the audiences. The free cash may be different from the net income in case of a explicit accounting period because the free cash flow usually takes into an account the increases required in working capital and consumptions of the capital goods and within a company, which is growing counting a 30 day compilation period for the receivables. A weekly payroll, a 30-day payment period for purchases, it will need more and more working capital for financing the operations because of the time for the receivables, although the total profits has enhanced.
Dividend growth model is a method of stock valuation, which deals with the calculations of dividends and the growth of the dividends, discounted to the present day.
According to the Dividend growth model, the basis of the valuation of stock is based upon the following:
Dividend Growth Model Formula:
A market multiples analysis is a method for financial modeling of conveying a cost to assets or to the business of an organization. Market multiples analysis is also termed to as straight assessment analysis or analogous company analysis. Used as a substitute approach towards economical cash flow valuation, a market multiples analysis uses analogous companies for deriving valuation (Allman, 2010).
A market multiples investigation can contrast companies based on industry classification, size, customers, growth, financial ratios, technology and leverage. Increased consistency and a stronger financial investigation are gained, when comparison companies are extremely similar. Usually a financial analyst evaluates what comparison factors are the most crucial and finds companies that are comparable based upon these factors (Larrabee & Voss, 2013).
Market products examination can be performed against the same number of diverse organizations as needed to acquire a solid valuation. For a general reference point of view, a private organization investigation can be performed. For more discriminating investigation and an abnormal state of exactness, a business products examination ought to be performed against a critical number of organizations inside of the same business (Thomas & Gup, 2010).
Market products investigation takes every organization to be looked at and computes the essential examination proportions. Standard monetary proportions incorporate liquidity proportions, resource turnover proportions, money related influence proportions, productivity proportions and profit approach proportions. A normal of the correlation proportions is performed and it brings about evaluation esteem. Taking into account the subsequent worth, an examiner makes a valuation judgment in light of nonfinancial pointers and may make changes appropriately (Kraft & Schwartz, 2010).
Advantages
Market products examinations are straightforward, apply and use on the grounds that there is no requirement for anticipating money streams. Data is likewise simple to get from distributed reports of traded on an open market organizations like 10-K entries or yearly reports. A business sector products investigation is an ordinarily utilized instrument as a part of the legitimate and venture saving money fields (Cornell, 2013).
It can be hard to discover great practically identical organizations to match up against the examination organization. Without an equivalent organization, results can be problematic and can prompt an extensive variety of valuations. A business products examination likewise bars the time estimation of cash and expense of capital from an organization’s valuation. For instance, a business products investigation rejects fund charges and premium.
A business products investigation is a decent instrument when another valuation system is not fitting because of a short organization residency or quick development. Examination figures ought to be taken from the same time period from every organization to reject outside occasional or monetary business sector changes (Allman, 2010).
A set of possession in a business that has a superior assert upon the assets and earnings than the common stock, is often known as preferred stock. The dividend of the preferred stock must be paid before dividends of the common stockholders and any voting rights are not entitled for these shares (Cornell, 2013).
Estimated Value of Preferred Stock = Preferred Dividend / Required Return on the Stock
= $2.10 / 0.07 = $30
The comparison should start from the evaluation of the stock performance within the sub – industry and the sector. This evaluation will highlight the standing and the comparison of the same from the year of 2010 to 2014.
Year 1= 2(1+0.3)/(1+0.13)= 2.301 $
Year 2= 2.301(1+0.2)/(1+0.13)= 2.4435 $
Year 3= 2.4435(1+0.1)/(1+0.13)= 2.3786 $
After the third year the growth will be constant at 6% so the formula will be:
P=D0(1+g)/(k-g)
Year 4= 2.3786(1+0.06)/(0.13-0.06)= 36.0188 $
So the sock value will be:
P=2.301+2.4435+2.3786+36.0188= 43.1419 $
The comparison has been shown below:
|
Year |
Sub – Industry |
Sector |
|
2010 |
108.47 |
101.66 |
|
2011 |
135.77 |
124.39 |
|
2012 |
174.36 |
154.57 |
|
2013 |
222.55 |
178.99 |
|
2014 |
264.33 |
201.64 |
The comparison quiet clearly shows that the sector has been always below the benchmark of the industry. This also brings us to the fact that the sector has not been able to go at par with the industry benchmark, which is a massive negative element for the business sector.
|
Year |
Yield % |
|
1 |
6.60% |
|
2 |
6.75% |
|
3 |
7.00% |
|
4 |
7.20% |
|
5 |
7.45% |
The study of the above table and graph shows that the yield % has gone up from the year 2010 which is considered to be the 1st year and have increased continuously until the 5th year which is 2014. The detailed study will also highlight the fact that the increase has been quiet constant as the there was a increase of 0.15 % in the first year of 2011. Then the increase was recorder at 0.25 % in the next year of 2012. The third year of 2013 witnessed a increase of 0.20 % and the year 2014 had a increase of 0.25 %. The equal and even growth show that the market is quiet in balance and the firms is having a suitable position.
The study of the above table and graph shows that the earnings per share has increased constantly from the year 2010 and have ended at 1.81 in the year 2014. Therefore, the stock performance has increased with each of the passing year.
The dividend was not applicable in the years of 2010, 2011 and 2012 but has increased to 0.15 in the year of 2013 and has further increased to 0.62 in the last year of 2014. Further study also shows that the one – year return of the company was – 8.3 % and the same of the industry was 30.9 %. This difference can have a huge negative effect on the price of the stocks. Therefore, the company should achieve the industry benchmark.
The even yield curve at shorter maturities suggests that short-term interest rates are predicted to fall fairly in the near future, while the steep growing slope of the yield curve at longer maturities shows that interest rates further into the future are probable to go up. Since interest rates and expected inflation move together, the yield curve suggests that the marketplace expects inflation to drop reasonably in the near future but to go up later on.
The steep upward-sloping defer curve at shorter maturities suggests that short-term interest rates are usual to mount reasonably in the near future because the preliminary, steep upward slope indicates that the average of likely short-term interest charge in the near future is above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply.
The study concludes that the Weighted Average Cost of Capital (WACC) has been elaborated within the study at the desired section that will help the reader to understand the role of the same in the evaluation of the cost of capital of any firm. The study also concludes that the evaluation of stock and bond of a firm has a huge role to play in the financial status of the company.
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