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Investment: Bond and Stock Valuation

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This week's discussion is another area that I lack familiarity and direct life application. I have done simple evaluations of investment worth, but nothing scientific. The closest application of any of the rules would be the payback rule. For example, purchasing a good car can be a payback evaluation. The decision may be determined in adding a delivery service to a restaurant. You may calculate the average price of delivery to account for fuel, mileage, maintenance, and cost. Then you would evaluate the increased revenue to see how long you would have to run the service to pay for the vehicle investment, which will provide an evaluation of benefit. The drawbacks are that the payback rule ignores the time value of money, requires an arbitrary cutoff point, and ignores cash flows after the payback point. This leads to a biased result that doesn't fully represent the benefit of the investment. For example, the vehicle could run long after the payback point, but the benefits will be left out of the calculations.

Reference:
Ross, S., Westerfield, R., & Jordan, B. (2013). Fundamentals of Corporate Finance (10th). New York, NY: McGraw-Hill/Irwin.

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You are absolutely correct in your understanding of the simple payback rule. As you indicate it calculates your investment and then simply determines the time it takes to recoup that investment. There are a lot of drawbacks associated with the ...

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This solution discusses bond and stock valuation.

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Finance: Analyze three investments, value of each security, rate of return

You are considering three investments.

The first is a bond selling for $1,100: it has $1,000 par value, coupon rate of 13%, and 15-year maturity. For bonds in this risk class, it should offer 14% yield to maturity (rate of return).

The second is a preferred stock with $100 par value selling for $90 per share, with a $13 annual cash dividend - you require a 15% rate of return on this preferred stock.

The third is a common stock with $25 par value that pays a cash dividend of $2; earnings per share for the company increased from $3 to $6 over 10 years, and the growth in dividends will be the same as the growth in earnings per share. The market price of the stock is $20 per share, and you think a
reasonable rate of return on it is 20%.

A. Explain how to calculate the value of each security based on the stated required rate of return.

B. Which investment would you buy? Explain.

C. If your required rate of return changed to 12% for the bond, 14% for the preferred
stock, and 18% for the common stock, how would your answers to parts a and b
change? Don't do the calculations - explain how to do them.

D. Repeat part c with required rates of return of 20% on the common stock, with
anticipated constant growth rate changes to 12%.

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