Question No 02: Marks (10)

Bonds and stocks are two primary securities traded on approximately all stock exchanges of the world because of their potential, reliability, and better trade volume. Besides all these pro, the risk-taking behavior of different investors and the features associated with each class of security are vital ones that attract investors for earning a handsome return. Stocks are considered riskier with a higher return, whereas bonds accounted for low-risk investment with a guaranteed return. However, most investors formulate a portfolio of their investment with a combination of bonds and stocks for optimal return with a lesser degree of risk due to the diversification edge involved in it.

The formulation of such a portfolio lies in market factors and company-specific factors. The optimal return only can be achieved by a better judgment of both factors and evaluation of intrinsic prices of securities by some fundamental methods

A new investor wants to add bonds and shares to his portfolio and he has two options available with the following information.

1. Company ABC issued a five-year bond with the face value of Rs.1,000. The bond offers a 12% semiannual coupon payment. The market interest rate for such type of investment is 14% per annum while the current market price of a bond is Rs.940.

2. The stock of company XYZ is being sold at Rs.54 per share while the forecasted dividend is Rs.6 for the 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 the 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 the valuation of both investment options by calculating:

1. Intrinsic value of the bond.

2. Intrinsic Value of stock today.

3. Identify either bonds and stocks are overvalued or undervalued. Justify your answer with proper calculation and reasoning.