Hongyi is looking for some attractive investments to diversify his portfolio. After conducting extensive research, he has

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Question:

Hongyi is looking for some attractive investments to diversify his portfolio. After conducting extensive research, he has narrowed his choices to two options:

i) preference shares (issued by the Royal Bank of Canada (RBC)) and

ii) the 10-year bonds (issued by the Commonwealth government).

Each RBC preference share pays a constant dividend of $5 per share per annum indefinitely, with the first dividend being paid exactly one year from today. The required return is 8.0% p.a., compounded annually.

Each 10-year commonwealth government bond has a face value of $100,000 which will mature in 10 years. This means that the bondholder will receive $100,000 upon presenting the bond to the Government Treasury in 10 years. The bond also pays regular coupons of $3500 every six months over the next 10 years (i.e. 20 payments in total), with the first coupon being paid exactly 6 months from today.

The required return is 6.0% p.a., compounded semi-annually.

Hongyi would like to know the intrinsic (fair) value of these financial instruments. He remembers from a first-year corporate finance course at UNSW that the intrinsic value of a financial instrument is the present value of its future cash flows discounted at the required return.

1.Suppose Hongyi purchased one RBC preference share today. Calculate the current intrinsic value of this share.

2.Suppose Hongyi purchased 1,000 RBC preference shares for $197.97 each today. Calculate the Net Present Value (NPV) of this investment. Is the internal rate of return (IRR) higher than the required return of the shares?

3.Suppose Hongyi purchased the bond today. Calculate the current intrinsic value of the bond.

4.Suppose Hongyi purchased 10 Commonwealth government bonds today for $60000 each. Calculate the NPV of this investment. Is the IRR higher than the required return of the bond?