Question

1. You are the CFO of Ford Motors Inc. The firm has decided to purchase new fixed assets that will allow them to more efficiently produce electric cars. To raise the funds needed to purchase these assets, you decide to issue bonds. You expect the new fixed assets to last about 11 years so you’d like to issue bonds with a maturity of 11 years and a face value of $1,000. To set the coupon payment, you ask Moody’s what the credit rating is for bonds of this maturity and risk. They tell you they will rate your bonds Baa which have a 4% return per year, so you set the coupon at $40 per year.

a. What is the present value of the bond Ford is offering? Hint: Finding the price of a bond at the time when it is first issued shouldn’t take you long.

One year later, market interest rates on bonds of similar risk and maturity and increased to 5%. Pretend an investor is looking for a Baa rated bond with a maturity of ten years. They have two choices. They can buy a newly issued bond with a face value of $1,000, say from Toyota. The coupon rate on this newly issued bond would be equal to the current market rate of interest, 5%. This means they would get a coupon of $50 each year. The price of the Toyota bond would be $1,000. The investor’s other option is to buy the Ford bond since it also has a maturity of ten years since one year has past. The coupon for the Ford bond is still $40 and the coupon rate for the Ford bond is still 4%.

b. In order to attract investors, would the price of the Ford bond have to be more or less than the price of the Toyota bond? In other words, does the Ford bond have to be sold at a premium (for more than $1,000) or at a discount (for less than $1,000)? Why?

c. Find the price of the Ford bond.

Answer 1

Part (a):

At the time of issue, since the coupon rate is equal to yield required, issue price is equal to face value, ie., $1,000.

Part (b):

Required yield is 5% while the Ford bond gives coupon rate of 4%. Therefore, in order to attract investors, price of Ford bond should be less than the Toyota bond which has 5% coupon rate. That means, the Ford bond has to be sold at a discount (for less than $1,000). Because the PV of coupon at lower rate of 4%, together with the PV of face value (on redemption), discounted at the higher yield rate of 5%, should be equal to the price.

Part (c ):

Price of the Ford bond= $922.78 as follows: