Question 3 a) The prospect of hydrogen based green energy has recently generated a lot of enthusiasm among the investors. Hygro Corporation is one of the few companies that purely focus on the hydrogen powered automotive solutions. Since its IPO, Hygro has generated small but steady revenue each year over the last five years. This year, for the first time the company has posted positive earnings of $2 per share and distributed 20% of its earnings as dividends. The rest of the earnings is retained and invested in projects that are expected to earn a 25% return on equity per annum. Hygro's current systematic risk or beta is 1.8, current market risk premium is 8.5% pa and risk free rate is 5% pa. Kyla, a trainee equity analyst at Harvest Financial Research, has been asked to estimate the intrinsic value of Hygro Corporation's equity shares. Kyla uses the Dividend Discount Model and the information provided above for this purpose. Her calculations are provided below: Kyla's calculations of the intrinsic value of Hygro's equity share: Growth rate(g) ROE b = 0.25 (1 0.2) = 0.2 = 20% - Required Rate of Return(k) = R + (Rm R) = 0.05 + 1.8(0.085) = 0.203 = 20.3% This year's Dividend(D0) = $2 0.2 = $0.4 Next year's Dividend(D) = Do (1+ g) = $0.4 (1+0.2) = $0.48 0.48 Value(V) = D1 (k - g) = - $160 (0.203 -0.2) i. Identify 3 main assumptions in Kyla's valuation of Hygro's equity. Comment if these assumptions are reasonable or not? ii. Kyla's boss, Lauren suggested that due to Hygro's position in the industry life cycle, a constant dividend discount model may not be suitable for its valuation. Based on the information given above, at what stage of the industry life cycle Hygro is currently in? iii. Based on the valuation models you have learned in your "Equities and Investment Analysis" class, can you suggest a more suitable valuation model that Kyla might use to value Hygro's equity? Justify your answer with a brief explanation. b) The optimal risky portfolio (P) provides expected return of 12% pa with 20% standard deviation. The risk free rate of return (r) is 3% pa. Based on this information Robert draws the following Capital Allocation Line (CAL) to identify his complete investment portfolio. Robert expects to earn 10.2% pa return from his investments. Axis Y? Capital Allocation Line (CAL) 12% R = 3% A 6% C Optimal Risky Portfolio (P) 20% Axis X? i. Identify the labels for Axis X and Axis Y in the Chart above. ii. iii. Among the portfolios represented by the points A, B, C and D on the graph identify Robert's complete portfolio. Justify your answer. - Based on Robert's return expectation, what proportion of his wealth should be invested in the risk-free asset?