APM Fund Management is considering the following options for their new investment portfolio:
Option 1 – A non-callable corporate bond that pays coupon rate of 9% annually. The bond will be mature in 20 years. The year-to-maturity (YTM) of the bond is 7.5% and the face value of the bond is $1 000.
Option 2 – An ordinary share which just paid a dividend of $7.50 with a constant dividend growth rate of 5% each year. The current market price of this share is $112.50.
Option 3 – A $100 par value preference share which pays a fixed dividend of 13%. The required rate of return of the preference shares in the same group is 12%.
Required:
- How much should APM pay for the corporate bond? If the coupon rate is paid semi-annually, how much is the bond value?
- Calculate the market required rate of return for the ordinary share. Calculate the share value if the market required rate of return is 10%?
- Compute the value of the preference share and explain why the preference share is considered a hybrid between an equity and a debt instrument?
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