Question

2. XYZ company has issued a bond with 25 years of maturity and coupon rate of 10 percent per annum. The face value of the bond is 1 million dollars. The bond makes coupon payments semi-annually. The yield to maturity is 14 percent per annum.

1. Why might XYZ chose to raise capital this way? In your answer explain what other options are available to the company to raise funds.
2. What is the price of the bond today? Explain why the price is different to the face value.
3. A broker has offered this bond for $585,000.00. Would you buy it? Why or why not?                                                                                                                          (Marks 2 + 1 + 1 = 4)

3. ABC company has paid an annual dividend of $4 this year. Market forecasting indicates that the annual dividend of ABC is expected to grow as per the annual growth rates shown in the following table. It is also assumed that the fourth year’s growth rate is expected to remain constant in the foreseeable future. The opportunity cost of capital is 12% p.a.

Year	1	2	3	4
Dividend growth rate	5%	7%	6%	6%

1. Calculate the present value of an ABC share.

A broker offers this share for $40. Would you buy it? Why or why not explain your answer?

Answer 1

Calculation of price of bond today
Semi annual coupon interest	10*6/12= 5%
Semi annual yield to maturity	14*6/12 = 7%
Number of periods =25*2 =50 years
Coupon interest=	1000000*5%=50000
Price of bond = C/(1+r) +….C/(1+r)1-50+ Maturity amount/(1+r)50 r is yield to maturity

50000/(1+0.07)+50000/(1+0.07)1-50+1000000/(1+.07)50

46729+50000* 13.80 +1000000*0.034

Price of bond today = $ 770729

Company prefers to issue bond due to lower overall cost of capital. Issuing bonds also lead to reduction in tax liability due to interest cost which will result in higher profits. The finance cost of company also remain fixed. It does not fluctuates. Higher profits also result in enhancement of wealth of shareholders.

Other methods of raising capital by company could be through:

Shares where funds are raised through issue of initial public offer or future public offer by the company. Company may issue ordinary, preference or deferred shares.

Company may also raise funds directly from public through public deposits where fixed capital is raised for fixed period.

Price of bond is different than face value of bond due to time value factors. Also Coupon rate is lower than yield to maturity which means bond is selling at discount. Accordingly price of bond today is 770729 which is less than 10,00,000.

Broker is offering bond at $5,80,000 which is cheaper than the price of $770729. Bond should be purchased from broker.

Year	Growth rate	Dividend
1	5	=	4*105%=4.2
2	7	=	4.2*107%=4.49
3	6	=	4.49*106%=4.76
4	6	=	4.76*106%=5.05
Value of share today

Price of share = D/(1+r) +D/(1+r)²+D/(1+r)³+D/(1+r)⁴

4.2/1.12¹+4.49/1.12²+4.76/1.12³+5.05/1.12⁴

=4*0.893+4.49*0.79+4.76*0.71+5.05*0.63

=$13.680

Broker is offering the share at $40 while the value of share in market is $13.680. It is better to buy from market.