Question

QUESTION 25

1. Garey Ltd has just issued debentures with a face value of $100,000. The current market yields are 8% per annum. The debenture pays 10% per annum half-yearly coupons and on issue has 10 years to maturity.

   (a) Calculate the price of the debenture on issue.

   (b) As an investor you have purchased a debenture on the date of issue. You have held it for 2 years and have watched the current yield fall to 6% p.a. If you were to sell the debenture after holding it for 2 years calculate how much profit or loss you would make from its sale.

   (c) With respect to the risk associated with investing in a debt security explain the major difference between debentures and unsecured notes. From the investor's point of view what is the implication of this difference if a company that has issued both debentures and unsecured notes goes into liquidation.

Answer 1

Solution a) Face value (FV) = $100,000

Coupon rate = 10% semi-annual payment

Coupon rate per period = 10%/2 = 5%

Coupon amount (PMT) = 5%*Face Value = 5%*100,000 = $5,000

Number of years = 10 years

Number of periods (Nper) = 10*2 = 20

Current market yields = 8%

On a semi-annual basis, current market yield = 8%/2 = 4%

Rate = 4%

The current price of the bond is calculated using the PV function in Excel = PV(Rate, Nper, PMT, FV, Type)

= PV(4%, 20, 5000, 100000, 0)

= $113,590.33

Solution b) New Current Yield = 6%

On a semi-annual basis, current market yield = 6%/2 = 3%

Rate = 4%

Face value (FV) = $100,000

Coupon rate = 10% semi-annual payment

Coupon rate per period = 10%/2 = 5%

Coupon amount (PMT) = 5%*Face Value = 5%*100,000 = $5,000

Number of years left = 8 years

Number of periods (Nper) = 8*2 = 16

The current price of the bond is calculated using the PV function in Excel = PV(Rate, Nper, PMT, FV, Type)

= PV(3%, 16, 5000,100000,0)

= $125,122.20

Profit from the sale of the debenture = 125,122.20 - 113,590.33 = $11,531.87

Solution c) Debentures and unsecured note are similar in the manner that both have no collateral attached to them and are a form of unsecured debt. While the difference is that unsecured note is considered riskier than the debenture and thus, offers high yield than the debentures.

Another major difference from the investor's perspective is that debentures have insurance policies attached to it which are used to payout in case of default while unsecured note does not have any insurance attached to it.

Thus, in the case of liquidation, investors can exercise the insurance and will get principal recovery. Also, debentures have more preference than the unsecured note during the liquidation.

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