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IA new investor wants to add bonds and shares in his portfolio and he has two options available with the following information.
I. Company ABC issued a five-year bond with face value of Rs.1,000. The bond offers 12% semiannual coupon payment. The market interest rate for such type of investment is 14% per annum while current market price of bond is Rs.940.
II. The stock of company XYZ is being sold at Rs.54 per share while the forecasted dividend is Rs.6 for first year and Rs.7 for the second year. The price of the stock after year 2 is expected to be Rs.55. The Company paid most recent dividend as Rs.5 whereas the rate of return for such type of investment is 14% per annum.
You are required to help the investor in valuation of both investment options by calculating:
Intrinsic value of the bond. (8 marks)
Intrinsic Value of stock today. (8 marks)
Identify either bond and stocks are overvalued or undervalued. Justify your answer with proper calculation and reasoning. (4 Marks)
Intrinsic value of the stock
Do = Current dividend = Rs.5 D1 = Rs.6
D2 = Rs.7
Value of Stock:
Po = D1/ (1+i)n + D2/ (1+i)n + P2/(1+i)n Po = 6/ (1.14)1+ 7/ (1.14)2 + 55/ (1.14)2 Po = 5.26+5.39+42.32
Po = Rs.52.97
Bond and Stock valuation Solution
Overvaluation or undervaluation of securities
Bond is overvalued because market price is more than intrinsic value i.e. Market price > Intrinsic value
940 > 929.76
Stick is also overvalued as its market price is more than its intrinsic value i.e. Market price > Intrinsic value
54 > 52.97