Questions Based on Investment Answer 1a Money earns interest and money is to inflation that the inflation brings down its future value. Thesetwo are the reasons for applying a discount factor while calculating a present value of any future revenue or income from shares or bonds. Answer 1b (i) Topgrade’s bond have annual coupon of 4% and nominal value is £75 so annual interest earned will be 75×4/100 = £3.0, Since it is paid in two equal installments every six months, the interest payment will be £1.5 (ii) The present value of bond that will be redeemed at £75 can be calculated as 75/ (1+r) n, where r is discount rate and n are number of years.
In our case, discount rate is 3.5% and n=5 as it will be redeemed after 5 years. PV= 75/(1.035)5 = 63.1844 However, the present value of interest streams received must be added in the above. Since interest is received every 6 months, discount rate applied will be 3.5/2=1.75% That can be given as Present value of streams of interest earned 1.5/1.0175 + 1.5/(1.0175)2 +1.5/(1.0175)3+………………. 1.5/(1.0175)10 = £13.65 Total PV of the streams = 63.18+13.65= £76.83 Current market price of the bond is £78, which is higher than the total present value of benefits accrued including interest earned hence bond is not worth buying. Answer 1c Recent dividend is £2 and it is increasing at the rate of 2% hence in next 5 years dividend stream will be 2.04, 2.0808, 2.1224, 2.1648, and 2.2080. The present value of dividend streams applying discount factor of 3.5% can be given as 2.04/1.035+2.0808/ (1.035)2+2.1224/(1.035)3+2.1648/(1.035)4+2.2080/(1.035)5 = 1.97+1.94+1.92+1.89+1.86 = £ 9.58 Also, the share was sold at £80 after 5 years Hence, its present value will be 80/ (1.035)5 = £ 67.39 Present value of the total money received = 9.58 +67.39= £76.97 The current value of the share purchased is £76.
Thus, it is clear that trading in this share will give a slight benefit of only £ 0.97. It is not worth buying the share. Answer 1d i) Shares are riskier than bonds. Hence, it needs to apply higher discount rate. ii) Raising the discount rate to 4% will bring down the present value of the future income. In short, the present value will be less than the current purchase price including dividend received for 5 years.
Therefore, it will not be worth buying at all. Answer 1e Company details Share price £ Earnings per share Price-earnings ratio (calculated) Topgrade current financials 76 1.65 46 Topgrade prospective, 2012 76 2.25 34 Source: Table 1 Current price-earnings ratio for Topgrade comes to 46 which is way high than industry average P/E of 25. Share of Topgrade is thus, overvalued. Even from the view point of future (2012) prospects, P/E comes to 34 that is still high. That means that Topgrade share is overvalued from this point of view too.
It is not worth buying. Part B Introduction There are various avenues available for investment; however, all pose different risks in reference to the capital invested, income earned and towards it liquidity. Investment avenues are varied and wide, right from government security to deposit in savings account of bank and from investment in prominent shares to fixed coupon bonds. House offers a safest investment with decent returns over time. Renting the house offers another avenue for a regular monthly stream of income. It will be interesting to see the risk profile in view of the five investments options for £ 30,000 as available.
For Investment made £ 30,000 in a solid saving account from a UK-based building society the Capital risk is minimal as being a saving account and usually deposits to a certain extent are backed by insurance and government body. It offers 0.5% interest; again there is no risk involved on income. Instant access is available so liquidity is excellent; however, given 2% inflation is sure to depreciate the investment. Used as deposit on a house with balance £ 120,000 being financed from outside source, the associated capital Risk is nil assuming all the mortgage payments are paid regularly.
Income will come in terms of house appreciation or rent realized, if not used for a self occupancy. As far as liquidity risk is concerned, it is almost nonexistent. Usually, disposing a house and converting it to cash is not an issue. Investment in UK government bond is not only highly safe but liquidity is also great. There is always a secondary market available to transact for the government bond. There is no risk associated with income too.
In fact, it is a safest instrument from all the respects. Since redemption yield is 4%, it is like to give positive return net off inflation (2% current). Investment in the share of Utility Max is highly liquid but the capital risk is higher too. Standard deviation is a measure of volatility and risk related to capital. Higher the standard deviation means higher the volatility in the share price and that indicates higher risk profile of a share. The expected rate of return is 5% which can be said to be moderate for the inflation rate of 2%.
For investment in the share of Allnew plc, expected return is 12% but standard deviation is 22%. This is certainly an investment with high capital risk. It provides an avenue for decent return with higher capital risk. As normally the case with all shares, liquidity is excellent. In the event, if inflation shoots up to 10% from 2%, it will have a serious bearing on the investments made on different instruments.
For Investment made in a solid saving account from a UK-based building, though risk on capital is nil but investment tends to depreciate by almost 10% (inflation rate) as buying power of pound sterling is reduced substantially in tandem with the inflation. In that sense, the capital is in risk with no return in real terms. Usually, house price and rent both move up in line with the inflation. This is surely a safer investment in the high inflation regime. Capital, and income risk is lowest. Liquidity is excellent. Investment in UK government bond surely will reduce the real capital as return is only 4% and inflation is 10%.
The capital is likely to depreciate at the rate of around 6 percent, if inflation continues to hover in that range for a long time. Real return comes to nil. However, liquidity will continue to remain excellent with government bonds. Shares will always remain a high return and high risk investment. In high inflation regime, people tend to go for investment in shares as it can beat the inflation by sufficient margin. So far risk profile is concerned with respects to capital and return both will continue to remain an issue to be taken care of.
Conclusion Risk and return from investment go hand in hand. Higher the associated capital risk in an investment means the chance of high return from it. Moreover, it is quite likely that along with inflation share price will firm up for the reason of less available avenues as money will come out of the bond and fixed interest instruments and search for high rate of returns. Inflation increases the capital requirement for any business that also tends to up the share price in the market for the existing businesses as that will come in the way for a new entity as entry barrier; however, that does not lessen the capital risk in an instrument.
Reference Present value, online from http: //www. financeprofessor. com/financenotes/introductoryfin/presentvalue. htm [Accessed on 7/1/2011]