Question

1.If you are a risk-averse investor that is buying a bond, which of the following features would you prefer:

Secured by collateral

Sinking fund

Callable

Protective covenants

2. How would an upgrade on a bond’s credit rating (say from BBB to AA) affect its yield?

3.Microsoft currently pays a dividend of $2.50. The company’s goal is to increase dividends by 4% each year. You, the investor, require a rate of return of 12%. What is the current price you would pay now for a share in Microsoft? What will Microsoft’s dividend be in five years?

Answer 1

1)

If I was a risk-averse investor that is buying a bond, I would prefer the bond to be secured by collateral. The secured collateral would serve as protection for the investor when the company defaults and has to be liquidated. The Bond investor in this case would expect to receive atleast his principal or face value amount on liquidation but it is subject to the selling the secured collateral at the market price.

Sinking fund requires periodic payments to a fund to redeem part of the Bond issue every year. This is subject to the performance of the company. They company may not fulfill this obligation.

Callable gives the right to the issuer to call back the bonds at a predetermined price after a certain time period. This is to the detriment to the Bond holder.

Protective covenants only restrict the Bond issuer performing certain activities such as issue new debt, take more risky projects.

2)

An upgrade on a bond’s credit rating (say from BBB to AA) will reduce its required yield since the Default risk premium required by investors would reduce. The reduction in Default risk premium would reduce the bond's required yield.

Bond Yield = Real risk free rate + Inflation premium + Maturity premium + Default risk premium + Liquidity premium

3)

Share price of Microsoft = Current Dividend * (1 + growth rate) / (Required return - growth rate)

Share price of Microsoft = $2.50 * (1 + 4%) / (12% - 4%)

Share price of Microsoft = $32.5

Dividend in five years = Current Dividend * (1 + growth rate)⁵

Dividend in five years = $2.50 * (1 + 4%)⁵

Dividend in five years = $3.04