In March 2015, you joined a private banking firm as a relationship manager. As your first assignment, your boss asked you to join her for a client meeting with Mr. Liew. During your discussion with client, you understand that Mr. Liew is 60 years old this year and has recently divested his logistics and transportation business for $1.5 million. He intends to retire and hopes to invest the proceeds in income generating financial assets.
In particular, he mentioned this stock called ‘China Merchants Holdings (Pacific) Limited’ (“CMH”) pays decent dividends. This company is a leading toll road company focused on investing in and managing toll roads in the PRC. It is currently trading at $1.10 and he is unsure if this is an attractive investment.
At your request, your firm’s equity research department furnished you with their 5-year dividend forecast for this counter:
|Year||Dividend Per Share (Cents)|
The dividends are anticipated to grow at 4% a year from 2020 onwards. They also told you that the market risk premium is 5% and the risk-free rate is 3%. The beta and standard deviation of CMH is 0.9 and 25% respectively.
Alternatively, Mr. Liew is thinking of allocating a certain portion of his investments in a safer asset class like bonds. You suggested for him to consider bonds issued by OCBC bank and the salient terms are detailed as follows:
- Issue date = March 2009
- Amount issued = $712 million
- Maturity date = March 2019
- Interest = 5.60% a year (before March 2014) and 7.35% a year thereafter
- Payment = Semi-annually
- Par value = $100.00
OCBC received an Aa2 credit rating by Moody’s and the credit spread for corporate bonds with similar rating is 1%. The standard deviation of OCBC bond is 10% and the correlation coefficient between CMH and OCBC bonds is -0.6.
The third option is to purchase a life annuity offered by your firm. This annuity scheme will make a payout of $2,000 at the end of each month for as long as policyholder shall live. Given Mr. Liew’s health condition, he expects his life expectancy to be that of an average Singaporean, which is 82 years.
You will be having a follow-up meeting with Mr. Liew next week and your boss needs you to address the issues raised at the last meeting as well as evaluate the risk and return of a portfolio comprising CMH stock and OCBC bond in the following combinations:
|CMH stocky||OCBC bond|
Calculate China Merchants Holdings (Pacific) Limited’s cost of equity by applying the Capital Asset Pricing Model (CAPM).
Calculate the net present value of China Merchants Holdings (Pacific) Limited’s dividends and advise Mr. Liew whether he should consider investing in this stock
Apply principle of time value of money to calculate the fair market value of OCBC bond.
Calculate the value of the life annuity offered by your firm. Assume the interest rate for annuities to be 4%.
Calculate the expected return and standard deviation of the two-asset portfolio and plot a graph to illustrate the data points. Assume the expected return on CMH stock and OCBC bond is 9% and 4% respectively.
Recommend a portfolio mix to Mr. Liew on the presumption that he is a risk adverse investor.
‘The beta and standard deviation of CMH is 0.5 and 25% respectively.’
Distinguish between the two measures of risk i.e. beta and standard deviation