Finance Case Study Example

1)

Value of investment in bonds:

Coupon Rate = 6.35% Par Value = $1000
Value of Coupon = 6.35/100 * 1000 = $63.5

Cash Flow Schedule

Intrinsic Value = -1020 + 63.5/1.05 + 63.5/(1.05)^2 + 63.5/(1.05)^3 + 63.5/(1.05)^4 + 1063.5/(1.05)^5
Return on investment = 5.9%
Return on Investment = 5.9%

Return on Investment in Preferred Stock:

R = 2.63/26.25
= 10.2%

Return on Common Stock:

52 = 1.6/(0.12 – g)
6.24 – 52g = 1.6
g = (1.6 – 6.24) /52
g = 8.9%
Return on Common Stock = 8.9% + 1.6/52 = 8.9 + 3.1 = 12%
2) The best investment is the investment in bonds because it is the safest investment, and at the same time gives higher rate of return than the required rate of return. Hence, it is the best investment. The reason why the investment in the common stock is rejected is because it gives the return at par with the required rate of return. The IRR of such an investment is negative and hence this investment is not going to meet the investment appetite for the investment. Similarly, the rate of return on preferred stock is going to go down as the investment is going to increase in the form of increase in the prices of preferred stock. The yield to maturity of investing in bond is higher in bonds and has a positive IRR. Hence, such an investment is going to be more useful for the investor. Hence, the investment in bond should be preferred over the other investment alternatives available to this particular investor.
3) The 1% increase in growth rate is going to increase the return in terms of capital appreciation. However, as the capital is appreciated and the dividends rise, the dividend yield is likely to remain constant or increase only slightly. As a result, there is going to be an increase in the rate of return by approximately 1%. It is going to make the NPV of the return on investment positive in terms of required rate of return. This will make the investment worthwhile.

The calculation of this change:

Increase in Growth Rate = 8.9% + 1% = 9.9%
Dividend Yield = 3.1%
Total Return = 9.9 + 3.1 = 13%
The investment in stock is now going to be worthwhile, and investment in stock might be preferred over the investment in bonds and preferred stock because now it is compensating the risk of investing in a risky investment.
4) There will be different investment risk for each these investments. For bonds the interest rate risk will be very high. If the interest rates go down, then the YTM (Yield to Maturity) of this bond is going to rise, but if the interest rates go down the YTM of the bond is going to pose serious investment risk to the investment. Similarly, there will be a reinvestment risk once the bond is redeemed. For preferred stock again there will be interest rate risk because the investors will be stuck in fixed income security. Similarly, there is going to be a default risk and credit risk for investors in this instrument. For stockholders, there will be a default and credit risk. Similarly, if the company does not have enough cash it won’t be able to pay dividends to the investors. However, there will be no reinvestment or liquidity risk to the investors of the common stock instrument.