Mini Case - Chapter 4

AUST - Spring 2012-2013 FIN 500
Mohamad Fouad Itani ID 20080072
Chapter 4 Mini Case

a) What are the key features of a bond? A bond is a long-term contract under which a borrower agrees to make payments to the holders of the bond: (1) Payments of interest on specific dates (called Coupon payments, they are paid on yearly basis, semi-annual basis or quarterly basis) (2) Principal payment (called Face or Par Value, it is usually considered $1,000). Bonds are classified into four main types: Treasury, corporate, municipal, and foreign; Each type differs with respect to expected return and degree of risk. b) What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? Most corporate bonds contain a call provision, which gives the issuing corporation the right to call the bonds for redemption. The call provision generally states that the company must pay the bondholders an amount greater than the par value if they are called which is termed a call premium. Issuers use this provision to mitigate towards the changes in the market interest rates where by calling old bonds issuers will be able to issue new bonds with a lower Par Value. Sinking fund provision facilitates the orderly retirement of the bond issue; this is usually done by monthly payment of Face Value or purchasing of Face Value at simultaneous time intervals. These provisions make the bonds more risky as they are opposed to reduction of return rates. c) How is the value of any asset whose value is based on expected future cash flows determined? The value of any asset is the present value of the cash flows the asset is expected to produce; this is done by discounting the Par Values and the Face Value to be received by the amount of interest to the defined number of periods. d) How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent? The value of a bond is the present value of the cash flows the bond is expected to produce in the future including Par Values and the Face. VB = CP (1- (1+k)-n)/k) + (FV (1+k)-n) = (100(1- (1+0.1)-10)/0.1) + (1,000 (1+0.1)-10) = $1,000 When Par Value = Coupon rate VB=FV
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e) (1) What would be the value of the bond described in part d if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a premium bond? VB = CP (1- (1+k)-n)/k) + (FV (1+k)-n) = (100(1- (1+0.13)-10)/0.13) + (1,000 (1+0.13)-10) = $837.3 (2) What would happen to the bonds value if inflation fell, and rd declined to 7 percent? Would we now have a premium or a discount bond? VB = CP (1- (1+k)-n)/k) + (FV (1+k)-n) = (100(1- (1+0.07)-10)/0.07) + (1,000 (1+0.07)-10) = $1,211.1 The bond is at premium of $1,211.1 compared to the Face Value of $1,000 (3) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent? [Hint: With a financial calculator, enter PMT, I, FV, and N, and then change (override) N to see what happens to the PV as the bond approaches maturity.] Bond with 13% will fall in time to reach the $1,000 Face Value Bond with 7% will rise in time to reach the $1,000 Face Value f) (1) What is the yield to maturity on a 10-year, 9 percent, annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at a premium tells you about the relationship between rd and the bonds coupon rate? YTM1 = (CP + ((FV - VB)/n)) / ((FV + VB)/2) = (90 + ((1,000 - 887)/10)) / ((1,000 + 887)/2) = 0.107 10.7% YTM2 = (CP + ((FV - VB)/n)) / ((FV + VB)/2) = (90 + ((1,000 1,134.2)/10)) / ((1,000 + 1,134.2)/2) = 0.071 7.17% When bond sells at premium YTM < Coupon When bond sells at discount YTM > Coupon
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(2) What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.) Current Yield = Annual Coupon Payment / Current Price = 90 / 887 = 0.1014 = (1,000 887) / 887 = 0.1274 Total return = Current Yield - Capital Gain = 0.1014 - 0.1274 = - 0.026 -2.6% 10.14% 12.74% Capital Gain = Change in price / Beginning price
g) What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10-year bond? Why? The interest rate is the annual interest payment divided by the bonds current price. A 1 year bond has more interest risk rate due to the limited effect over its period. h) What is reinvestment rate risk? Which has more reinvestment rate risk, a 1year bond or a 10-year bond? Bonds with short maturities expose investors to high reinvestment rate risk, which is the risk that comes from a bond portfolio that uwill decline because cash flows received from bonds will be rolled over at lower interest rates. 1 year bond has more re-investment risk rate than that of 10 year bond. i) How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd = 13%. Usually we multiply number of periods by two and divide the coupon and required return by two then we apply the same formula. VB = CP (1- (1+k)-n)/k) + (FV (1+k)-n) = (50(1- (1+0.065)-20)/0.065) + (1,000 (1+0.065)-20) = $834.7 j) Suppose you could buy, for $1,000, either a 10 percent, 10-year, annual payment bond or a 10 percent, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If $1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond? (1) I would prefer to buy the semiannual payment bond due the compounding effect of its return which will yield in higher profit. (2) rd = PV = 10% since FV= VB = $1,000 for both.
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k) Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $1,000 is currently selling for $1,135.90, producing a nominal yield to maturity of 8 percent. However, the bond can be called after 5 years for a price of $1,050. (1) What is the bonds nominal yield to call (YTC)? (YTC/2) = (CP + ((CV - VB)/n)) / ((CV + VB)/2) = (50 + ((1,050 - 1,135.90)/20)) / ((1,050 + 1,135.90)/2) = 0.044 YTC=8.8%
(2) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why? I would earn YTM since YTC is lower than YTM and the issuer will prefer to keep the bond till maturity rather than paying additional money for no avail. l) Boeings bonds were issued with a yield to maturity of 7.5 percent. Does the yield to maturity represent the promised or expected return on the bond? This is the expected return on bond. m) Boeings bonds were rated AA by S&P. would you consider these bonds investment grade or junk bonds? These are grade bonds as they have high ranking. n) What factors determine a companys bond rating? The bond credit rating assesses the credit worthiness of a corporation's or government debt issues, these are assigned by credit rating agencies such as Moody's, Standard & Poor's, and Fitch Ratings to have letter designations (such as AAA, B, CC) which represent the quality of a bond, AAA refers to a prime bond rating while DDD refers to bonds in default.
o) If this firm were to default on the bonds, would the company be immediately
liquidated? Would the bondholders be assured of receiving all of their promised payments? When a firm is in default a decision must be taken whether to dissolve the firm through liquidation or to permit it to reorganize and stay alive if the value of the reorganized firm is likely to be greater than the value of the firms assets if they are sold off piece by piece. In case of liquidation, assets are sold off and the cash obtained is distributed according to the following priority of claims: 1. Past-due property taxes. 2. Secured creditors are entitled to the proceeds from the sale of the specific property that was used to support their loans.
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3. The trustees costs of administering and operating the bankrupt firm. 4. Expenses incurred after bankruptcy was filed. 5. Wages due workers, up to a limit of $2,000 per worker. 6. Claims for unpaid contributions to employee benefit plans, this amount, together with wages, cannot exceed $2,000 per worker. 7. Unsecured claims for customer deposits up to $900 per customer. 8. Federal, state, and local taxes due. 9. Unfunded pension plan liabilities. 10. General unsecured creditors. 11. Preferred stockholders, up to the par value of their stock. 12. Common stockholders, if anything is left.
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AUST - Spring 2012-2013 FIN 500

Mohamad Fouad Itani ID 20080072

Chapter 4 Mini Case

AUST - Spring 2012-2013 FIN 500

Mohamad Fouad Itani ID 20080072

AUST - Spring 2012-2013 FIN 500

Mohamad Fouad Itani ID 20080072

AUST - Spring 2012-2013 FIN 500

Mohamad Fouad Itani ID 20080072

AUST - Spring 2012-2013 FIN 500

Mohamad Fouad Itani ID 20080072

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