These questions were examined in the past exam questions.
Note: when making assumptions, you need to clearly state the reasons.
For example, the expected inflation is likely to be around the inflation target of the government.
Income cover
EBIT (earnings before interest and tax) / (annual interest + annual interest for all prior assets)
Capital cover (asset cover)
current liabilities are paid off, goodwill was removed from assets (make this statement before doing any calculations)
Remaining capital / (capital value of the asset and any prior assets) = (Debtors+Stock+Cash)-(Creditors+Overdraft+Tax Reserve)
Remember to produce adjusted balance sheet!
Remaining capital / (capital value of the asset and any prior assets) = (Debtors+Stock+Cash)-(Creditors+Overdraft+Tax Reserve)
Remember to produce adjusted balance sheet!
Expected vs required return
Expected return = running yield + expected growth rate
Expected return = running yield + expected inflation + expected real growth rate
Required return = risk-free rate of return + expected inflation + risk premium
Expected return = running yield + expected inflation + expected real growth rate
Required return = risk-free rate of return + expected inflation + risk premium
- For index-linked bonds, the required return always equals the expected return
- For conventional bonds, the expected return is exactly the yield in the market
- As the expected return equals the required return for index-linked bonds, only the expected return and the required return for the asset x need to be compared.
- Traditional method: yield gap: gross dividend yield on equities - GRY on benchmark long-dated bond
- Traditional method: reverse yield gap: GRY on benchmark long-dated bond - gross dividend yield on equities
- Practical method: GRY − d = inflation risk premium − equity risk premium + g
- GRY is the gross redemption yield of bond
- d represents the gross dividend yield on equities
- g is the nominal growth rate of the equities, it equals expected inflation + real growth rate
- If left hand side of the equation is larger, the conventional bonds appear to give better value
- On the contrary, if right hand side is larger, the equities give better value
- yield gap can be defined as: PRP − expected rental growth − (ERP − expected dividend growth)
- rental yield − GRY = PRP − expected rental growth − IRP
value of the share to the investor: $\frac{D_1}{r-g} $
the investor’s required dividend yield: $\frac{d}{p}=r-g$
target price earnings ratio: $ \frac{p}{e} = (d/e)/(r‐g)$
. Note d/e is the pay-out ratio
When comparing the required return and the expected return. We make the following simplifying assumptions:
- all investors want a real return (rather than a nominal return)
- all investors have the same investment time horizon
- tax differences between investors can be ignored
- reinvestment occurs at a rate equal to the expected return on the given asset
- inflation risk premium, premium to compensate for higher risk of default, premium to compensate for lower marketability.
- premium to compensate for higher risk of default,
- premium to compensate for lower marketability,
- premium to compensate for greater volatility (or uncertainty) in both income and capital.
- poor marketability,
- high dealing and management costs,
- risk of voids,
- risk of depreciation and obsolescence. this might be offset slightly by lower income and capital volatility in short term.
the DCF value of the notional portfolio
the DCF value of the notional fixed-interest bond portfolio is given by:
$\frac{p \times M_{all}}{M_{b}}\times DC_b$
where
$\frac{p \times M_{all}}{M_{b}}\times DC_b$
where
- p represents the proportion of portfolio in bond
- $M_{all}$ representsthe total market value
- $M_b$ represents the market value of the bond
- $DC_b$ represents discount cash flow value of the bond