Question

Decisions involving capital expenditures often require managers to weigh the costs and benefits of different options related to the financing of a project. For instance, deciding when to call a bond before maturity due to changing interest rates can lower the overall cost of a project significantly through refinancing. So, it is important to be able to understand the real interest rate being paid out to your bondholders (yield) at any given time.

For this Assignment, review the information presented in Problem 7-18 on page 267 of your course text. You will utilize the information in this week's readings and media to make a recommendation with regard to when to call a bond.

Prepare a spreadsheet using Excel or a similar program in which you compute the items listed in parts a, b, and d. Be sure to compute the Yield-to-Maturity (YTM) and Yield-to-Call (YTC) for each of years 5, 6, 7, 8, and 9. Utilizing Word, prepare a written report to your finance director:

Include a detailed explanation of the conclusion you reached concerning whether or not to call the bond before maturity.

If your recommendation is to call the bond early, explain when to call the bond and your rationale.

Discuss the advantages and disadvantages of using a long-term loan instead of a bond.

YIELD TO MATURITY AND YIELD TO CALL Kaufman Enterprises has bonds outstanding with a $1,000 face value and 10 years left until maturity. They have an 11% annual coupon payment, and their current price is $1,175. The bonds may be called in 5 years at 109% of face value (Call price =$1,090).

a. What is the yield to maturity?

b. What is the yield to call if they are called in 5 years?

c. Which yield might investors expect to earn on these bonds? Why?

d. The bond’s indenture indicates that the call provision gives the firm the right to call the bonds at the end of each year beginning in Year 5. In Year 5, the bonds may be called at 109% of face value; but in each of the next 4 years, the call percentage will decline by 1%. Thus, in Year 6, they may be called at 108% of face value; in Year 7, they may be called at 107% of face value; and so forth. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call the bonds?

Answer 1

Kaufman Enterprises

a) Bond coupon = 11% * $1000 = $110

So, the YTM (r) is given by

110/r*(1-1/(1+r)^10) + 1000/(1+r)^10 = 1175

Solving for r using solver , r = 0.083506 or 8.35%

So, Yield to maturity is 8.35%

b) If the bond is called in at 5 years at $1090

The YTC (y) is given by

110/y*(1-1/(1+y)^5) + 1090/(1+y)^5 = 1175

Solving for y using solver , y = 0.08132 or 8.13%

So, Yield to Call is 8.13%

c) The Investors should expect to receive 8.13% (YTC) on the bonds as the company would not like to pay a coupon rate which is higher than the yield to maturity to the Investors if the bonds can be called earlier.

d) If the bonds are called after 6 years at $1080

The YTC (y) is given by

110/y*(1-1/(1+y)^6) + 1080/(1+y)^6 = 1175

Solving for y using solver , y = 0.08267 or 8.27%

If the bonds are called after 7 years at $1070

The YTC (y) is given by

110/y*(1-1/(1+y)^7) + 1070/(1+y)^7 = 1175

Solving for y using solver , y = 0.083715 or 8.37%

If the bonds are called after 8 years at $1060

The YTC (y) is given by

110/y*(1-1/(1+y)^8) + 1060/(1+y)^8 = 1175

Solving for y using solver , y = 0.084565 or 8.46%

If the bonds are called after 9 years at $1050

The YTC (y) is given by

110/y*(1-1/(1+y)^9) + 1050/(1+y)^9 = 1175

Solving for y using solver , y = 0.085285 or 8.53%

In year 10, the bond will mature and yield to maturity 8.35% will be paid

So, it is in the best interest of the company to call the bonds as early as possible i.e. at the end of 5 years and pay a yield of 8.13% only as calling the bonds later will mean paying a higher yield

So, investors should expect the company to call the bonds after 5 years only