Question

Murphy’s Brewhouse was a rapidly expanding chain of home-brew bars. The beer was not very good, but hopes were high when the company went public three years ago, because of founder/owner Kevin Murphy’s promotional skills.

At the time the company went public, Murphy’s also issued $50 million of 20-year maturity debentures at a coupon rate of 9 percent. These debentures were sold at par ($1,000 per bond). Shortly after this debenture issue, Murphy’s received some very negative reviews, both in the gourmet beer magazines and on Wall Street. The company is currently struggling. Its stock has plummeted from $40 per share three years ago to less than $5. Earnings remain positive but disappointing at $0.03 per share, and the company is barely breaking even on a cash flow basis.

Murphy’s debentures are currently selling at 40 cents on the dollar. The debentures are callable two years from now at $1,090. If you require a 20 percent rate of return on investments of this perceived risk level, should you buy these debentures?

Answer 1

We are given,

The bond matures in = 2 years

Annual Coupon payment = 9% of $1000 = $90

Callable amount = $1,090

Yield to call = ?

Yield to call is the discount rate that makes the present value of the repayment of principal and interest with the present bond price.

We can compute it using the following formula,

where,

P0 = Current price of bond

I = Fixed amount of interest bond will pay indefinitely

kd = required return

n = no of yr until maturity

M = Maturity value

We can calculate the yield to call in excel,

Present Value	400
pmt / Annual coupon	90
no periods	2
Future/Callable Value	1,090
YTM	83.37%	(=Rate(2,90,-400,1090,0)

Hence the YTC is 83.37%.

The investor's required return is 20%. The YTC is far above the required return of the investor.

So, the investor should consider buying the bonds but with careful consideration. It could be beneficial if the company indeed calls the bond. However, the company is finding it hard to generate profits. The company must then benefit from having their debt reduced. Hence this transaction requires additional significant review before proceeding with the investment.

An upvote would be appreciated.