You are the chief investment officer of Alpha Finance Pte Ltd. One of your team members has just submitted an update on GekCo bonds and shares for your review.
• Current traded price: $1,050
• Par value: $1,000
• Coupon: 5%
• Tenor: 3 years to maturity
GekCo Ordinary Shares
• Current traded price: $9.80 per share
• Dividend (just paid): $1
• Dividends are expected to grow at 4% per annum
• Required return: 15%
At the same time, the board of directors asked you to review the company's capital budgeting policy. The current evaluation criteria are that the company will only invest in projects that achieve IRRs of at least 12%.
(a) Without calculating, infer if the yield to maturity of GekCo bond is higher or lower than its coupon of 5%.
(b) Using the dividend growth model (DGM), evaluate if you should buy GekCo shares.
(c) Shortly after you have submitted your recommendation as required in part (b), GekCo announces that it will be suspending its dividend payments for the upcoming year to conserve cash because of the uncertain market environment. Propose an alternative method (other than DGM) to evaluate whether to buy GekCo shares.
(d) Discuss two (2) limitations of using IRR for project evaluation.
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