1) You are analyzing the common stock of Sagarmatha Corporation for investment purpose. It is estimated that Sagarmatha will pay a dividend on its stock of Rs.5 per share this year. The dividend is expected to remain the same the following year, then increasing to Rs.7 the year after. From that point on, the dividend is expected to grow at 4% per year indefinitely. Stocks of other companies of the same industry with similar risk are currently priced to provide a 10% expected return. Based on the intrinsic value of the stock, would you invest on the stocks of Sagarmatha Corporation if they are selling at Rs.100 per share in the market?

2. Consider two 2-year bond strategies. The first strategy entails buying the Rs. 1,000 face value 2-year zero bond offering a 2-year yield of maturity of 10 percent, and holding it until maturity. The alternative strategies entails investing the same amount in a 1-year zero-coupon bond with a yield to maturity of 9 percent, and when the bond matures, reinvest the proceeds in another 1-year bond. If expectations theory holds true, what will be the interest rate that 1-year bonds will offer next year?

 

1

Intrinsic value of stock 150.68 is more than current market price of Rs 100. So it is underpriced. We should make investment in shares

2

interest rate that 1-year bonds will offer next year is 11.01%

Step-by-step explanation

Answer 1

Dividend next year (D1)=5

D2 = 5

D3 =7

Thereafter Dividend will grow at constant rate (g) =4%

expected return (ke)=10%

Price of stock at year 3 =D3*(1+g)/(ke-g)

=7*(1+4%)/(10%-6%)

=182

Present value or intrinsic value of stock is present value of future cash flows that is dividends received and price of stock at year 3

Intrinsic value of stock = (D1/(1+ke)^1) + (D2/(1+ke)^2)+(( D3+P3)/(1+ke)^3)

=(5/(1+10%)^1)+(5/(1+10%)^2) + ((7+ 182)/(1+10%)^3)

=150.6761833

Intrinsic value of stock 150.68 is more than current market price of Rs 100. So it is underpriced. We should make investment in shares

Answer 2

Alternative 1

2 year Zero coupon bond purchased has a YTM = 10%

So 2 year (n2 interest rate) =10%

Alternative 2

1 year zero coupon bond purchased has a YTM = 9%

So 1 year (n1 interest rate)=9%

Expectations theory say that Today if we invest in 2 year zero coupon bond or if we invest in 1 year bond and then reinvest after 1 year in 1 year bond, both strategies cumulative return will be same. Using this theory, 1 year interest rate after 1 year shall be calculated

1 year interest rate after 1 year = ((1+n2 interest rate)^2/(1+n1 interest rate)^1)^(1/(2-1))-1

=(((1+10%)^2/(1+9%)^1)^(1/1))-1

=0.1100917431 or 11.01%

So interest rate that 1-year bonds will offer next year is 11.01%