Principles Of Corporate Finance: Essentials Assessment Answer

 

owever, when the coupon rate is greater than the YTM, then the bond would trade at a premium (i.e. greater than the par value) since the coupon offered by the bond is greater than the expected yield on the bond due to which there is a greater demand of such bonds in the market. Additionally, when the coupon rate is lower than the YTM, then the bond would trade at a discount (i.e. lesser than par value) as the coupon offered by the bond is less than that expected by the investors (Kane & Marcus, 2013).

A decrease in the maturity date tends to decrease the YTM and thus increases the bond prices. Whereas, an increase in the maturity date tends to increase the YTM and thus decreases the bond prices (Parrino & Kidwell, 2011).

CAPM Approach

The completed table is shown below (Yahoo Finance, 2016).

Company	5-year Risk-Free Rate of Return	Beta (β)	5-Year Return on Top 500 Stocks	Required Rate of Return (CAPM)
Microsoft	1.45%	1.02	8.77%	8.92%
Apple	1.45%	1.06	8.77%	9.21%
IBM	1.45%	0.63	8.77%	6.06%

The risk–free rate is taken as the yield on US treasury 5 – year bond that comes out as 1.45% pa. The beta of the various stocks has been estimated from Yahoo Finance website.  As per the CAPM model (Brealey, Myers & Allen, 2008).

Required rate of return = Risk free rate + Beta*(Market return – Risk free rate)

Required rate of return (Microsoft) = 1.45 + 1.02*(8.77-1.45) = 8.92% pa

Required rate of return (Apple) = 1.45 + 1.06*(8.77-1.45) = 9.21% pa

Required rate of return (IBM) = 1.45 + 0.63*(8.77-1.45) = 6.06% pa

Valuation using Gordon Model

Company	Current Dividend ($)	Projected Growth Rate (next year)	Required Rate of Return (CAPM)	Estimated Stock Price (Gordon Model)	Current Stock Price	Over/Under Priced
Microsoft	1.24	4%	8.92%	26.2	50.80	Over
Apple	2.08	4.5%	9.21%	46.2	96.30	Over
IBM	5.2	3.5%	6.06%	210.2	129.56	Under

Estimated stock price (Microsoft) = 1.24*1.04/(0.0892-0.04) = $26.2

Estimated stock price (Apple) = 2.08*1.045/(0.0921-0.045) = $ 46.2

Estimated stock price (IBM) = 5.2*1.035/(0.0606-0.035) = $ 210.2

Valuation using P/E ratio

Company	Estimated Earning (next year)	P/E Ratio	Estimated Stock Price (P/E)	Current Stock Price	Over/Under Priced
Microsoft	3.12	33.51	104.5	50.80	Under
Apple	10.49	10.35	108.6	96.30	Under
IBM	15.01	8.97	133.14	129.56	Under

All the relevant data for the above table has been obtained from Yahoo Finance (2016).

As per the Gordon dividend growth model,

Estimated stock price = Dividend next year/(Required return – dividend growth rate)

Thus, the estimated stock price is inversely proportional to the required return on stock while it is directly proportional to the dividend growth rate. This is primarily because a higher dividend growth rate would increase the numerator and also would decrease the denominator and thus, lead to a higher estimated stock price.  Additionally, a higher dividend paying stock would have a higher value assuming that denominator remains constant similar to the higher price of a higher coupon paying bond assuming YTM as constant. As per the Gordon dividend model, the current stock is the present value of all the dividends that would be paid over the life of the stock assuming perpetual holding period (Kane & Marcus, 2013).

Advantage of Gordon Growth Model

It is an easy and convenient method to estimate the value of the stock of a particular company irrespective of the industry it belongs to (Parrino & Kidwell, 2011).

Disadvantages of Gordon Growth Model

It cannot be used to estimate the stock price of those companies that do not pay dividends (Marcus & Kane, 2013).

It does not give emphasis to factors other than dividends for the determination of stock price particularly the presence of intangible assets that are critical in modern knowledge based economy (Parrino & Kidwell, 2011).

The dividend growth does not remain constant and typically varies even for mature stocks.

The dividend growth rate always has to be lower than the required rate on equity that is not always true and thus, prices of such stocks cannot be determined (Damodaran, 2008).

The P/E approach primarily relies on estimation of EPS in the next year and multiplying that with the current P/E ratio so as to determine the estimated price of the stock in the next year assuming that P/E ratio remains constant (Parrino & Kidwell, 2011).

Hence, estimated value of stock = Current P/E ratio * Estimated EPS in the next year

The P/E model seems to be more accurate in determining the value of stock. This is primarily because the prices in the Gordon dividend growth model are highly sensitive to the dividend growth rate that cannot be predicted with high degree of accuracy in the future. As a result, the values obtained through P/E multiple are closer to the current market price (Brealey, Myers & Allen, 2008).

If the growth rate of the company would increase, then the value of the stock would increase as the next year dividend would increase while the denominator in Gordon growth model would decrease. An increase in the required rate of return would lower the stock value. Further, an increase in the dividends would increase the stock price in line with the Gordon growth model where the stock price is directly proportional to the dividends being paid. If the EPS of the stock would increase, then the stock price would increase due to higher profitability in line with the P/E approach (Damodaran, 2008).

References

Brealey, R., Myers, S. & Allen, F. (2008), Principles of Corporate Finance, New York: McGraw Hill Publications

Damodaran, A. (2008), Corporate Finance, London: Wiley Publications

Kane, B.Z. & Marcus, A.J. (2013). Essentials of Investment, Singapore: McGraw-Hill International

Morningstar (2016a), Verizon Communications Inc, MorningStar Website, Retrieved on  January 12, 2016  https://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=vz

Morningstar (2016b), KLA-Tencor Corp, MorningStar Website, Retrieved on January 12, 2016  ttp://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=KLAC&country=USA 

Morningstar (2016c), Oracle Corp, MorningStar Website, Retrieved on January 12, 2016 https://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=ORCL&country=USA

Parrino, R. & Kidwell, D. (2011), Fundamentals of Corporate Finance, London: Wiley Publications

Yahoo Finance (2016), Historical prices, Yahoo Finance, Retrieved on January 12, 2016  https://finance.yahoo.com/