Essentials of Financial Management

Question 1

When researching which corporate bonds to invest, you noted that some bonds were trading at a premium (e.g. 4.7% coupon bonds issued by BSD Ltd was trading at 5% above its par value), whereas some were trading at a discount (e.g. 5.25% coupon bonds issued by API Ltd was trading 2% below its par value). 

(a) Hypothesise four (4) reasons for your observations. 

(12 marks) 

(b) Market data obtained from S&P Capital IQ is shown below: 

 VMX Ltd has a beta of 1.3 and debt-to-equity ratio of 0.5 

 Yield on long-term Singapore government bonds = 3% 

 Yield on AAA-rated corporate bonds = 5% 

 Bond price issued by VMX Ltd = $1,150 (6% coupon, paid semiannually, 

expiring in 8 years) 

 Inflation rate = 1% 

 Market risk premium = 6% 

 Corporate tax rate is 17%. 

Solve for VMX’s weighted average cost of capital. 

(8 marks) 

(c) VMX stock is currently trading at $25.80. Its most recent reported earnings per share was $1.20. Based on guidance provided by anagement at the recent investor’s conference, earnings are expected to grow at 20% per year for the next 3 years, and 3% thereafter. The estimated dividend pay-out ratio is 50% for the next 3 years and 75% thereafter. Verify whether VMX stock is correctly priced by the market. 

(8 marks) 

(d) The market value of EEL Ltd’s equity is $50 million and it has $5 million debt. Management intends to issue bonds $20 million worth of bonds and use the proceeds to repurchase some outstanding shares.  

Examine whether the value of EEL will increase or decrease under the following scenarios: (i) no corporate tax and no bankruptcy costs, (ii) corporate tax rate is 17% and no bankruptcy costs and (iii) corporate tax rate is 17% and with bankruptcy costs. 

(10 marks)

 Question 2

You have been entrusted with $500,000 to invest. The following information relating to three stocks have been given to you: (Please refer to attachment for the data)

Average returns of long-term corporate bonds and long-term government bonds are 5% and 3%, respectively. Market risk premium is 6% and country risk premium is 2%.  

(a) Construct a portfolio that has a beta equal to the market and at least $50,000 must be invested in each stock. 

(10 marks)