The two questions of Assignment One have a combined maximum length is 750 words. You have discretion with regard to how your total word count of 750 is used across the two questions. The word count does not refer to your computational results which you will be interpreting and explaining. Appendices themselves will not be marked but may be referred to in the text. Inappropriate use of appendices, however, will be taken into consideration when awarding the final mark. Please answer the two questions in the order provided.
You will be assessed for the correctness of your answers to objective components and the quality of your discursive response which may involve accessing and using a range of sources. In total, there are two questions with sub-parts.
Q1. As an equity analyst for a fund, your main activity is seeking out shares which may be undervalued. In the last week, you have received information about two shares that you have been examining, Rentokil Initial plc and Bellway Homes. Many analysts according to the financial press believe that Style Group’s shares and Bellway shares are under-valued because their price-earnings ratios are lower than the industry average. Style Group has a P/E ratio of 6 versus an industry average P/E ratio of 8. Although expected to lower costs in the future, an announcement that its quarterly earnings would be lower than expected due to expenses from recent restructuring, did lead to share prices falling. Bellway Homes has a P/E ratio of 9 versus an industry average of 11. Its earnings have been decent in recent years because of demand for new homes but it has not kept abreast of new technology which lower cost and it is feared may lose market share to competitors.
a. Using relevant theory to make to make your case, do you agree with the argument that the share price of Style Group is undervalued and therefore should be purchased? (25 marks).
b. If Bellway had a correlation with the market (Beta) were 1.2, based upon the following data would you still agree that it is under-valued and should be purchased? Explain why or why not. (25 marks)
Market Return. 12%
Risk Free Rate 3%
Return on Equity for Bellway 12.5%
c. According to economic forecasts, interest rates can be expected to increase because of improving economic conditions. According to some analysts the prices of most shares will fall because interest rates are expected to rise but according to other analysts share prices may not fall because of the potential for off-setting capital gains. Do you agree with either perspective? Explain why? (25 marks).
d. On the whole, how useful do you find this discussion around Financial Ratios such as P/E or other financial ratios? What other perspectives and models might be more helpful and why? (25 marks).
Q2. For many reasons the Egyptian economy has faced many difficulties in recent years. Prior to recent reforms, the Egyptian inflation rate, according to the IMF was running at an annual interest rate of 15%. At the time the base lending rate (prime rate as charged to the best borrowers) was 21%. With the new Reserve Bank Governor Tarek Amer in 2015, it was hoped that control over inflation would be improved although it was feared by some investors that higher rates and tighter credit would to economic contraction. Given the following historic data, please answer the following questions. (It is strongly advised that you do your calculations in an Excel Spreadsheet and then copy your tables of results and graph into a Word document.). Send me both documents.
a. What was the average expected inflation rate over the five (5) year period between 2014 and 2018? (10 marks)
b. If you purchased 5-year Treasury Bonds issued by the Central Bank of Egypt in 2014, what nominal yield should have been offered in order to provide a 2% real risk-free rate of return assuming a maturity premium of 2.93%. Explain your results. (15 marks)
c. If the real risk-free rate on the shortest Egyptian government securities were 2% in 2014 and the maturity premium for one year were 2% and increases at a compound annual rate of 10%, what would have been the interest rate in January 2014 on government bonds that mature in 2, 5, 10 and 20 years. Using this data, plot these results on a yield curve. Under what market sentiment might the maturity premium increase? (15 marks)
d. If before the change of Reserve Bank Governor, investors in early 2014 had expected the inflation rate for every year to be 10% instead of the data shown above, how would the yield curve have shifted? Explain why. (20 marks)
e. If after Year 5, 2019, the Maturity Premium rather than growing at a compound rate as mentioned began to fall by 10% per year, what sort of Yield Curve would we observe and what might indicate on the outlook for the Egyptian economy? (20 marks)
f. More generally, explain the factors affect the Yield Curve and the extent to which a Pure Expectations theory may not hold and why. (20 marks)