Question

ABC Aviation Corporation, a subsidiary of XYZ Aviation Corporation, sold some securities to the public on June 15, 2017. The securities were bought and sold on the New York Stock Exchange. The terms of the deal are as follows: Promise to repay the owner of one of these securities $100,000 on June 15, 2047 The securities DO NOT pay interest ABC has the right to buy back the securities on the anniversary date at a price established at the time of sale Investors paid ABC $24,500 for each of these securities

Discuss

Why would ABC be willing to accept such a small amount today ($24,500) in exchange for a promise to repay approximately 4 times that amount in the future?

What impact does the buyback feature have on the desirability of the investment? Would you be willing to pay $24,500 in exchange for $100,000 in 30 years?

What would be your key consideration in answering yes or no?

If the U.S. Treasury had offered basically an identical security, do you think it would have a higher or lower price? Why?

If you looked at the New York Stock Exchange price of the stock TODAY, do you think the price would exceed the $24,500 original price? Why?

If you looked in the year 2025, do you think the price would be higher or lower than today's price? Why?

Answer 1

ABC would be willing to accept such a small amount today ($24,500) in exchange for a promise to repay approximately 4 times that amount in the future due to the following:

1. If you consider the effective compounded rate of return, then it comes to 4.8% which is reasonable as the company expects to earn more than 4.8% over the course of 30 years

2. The buy back feature will be only exercised when it is advantageous to the company, which is not good for the security investor as he faces a reinvestment risk. The company buying back stock is usually a good sign and indicates that the company is expected to perform better in the future. However, the investor will loose an opportunity to participate in the upside. Thus, the desirability of the investment reduces. However, if the buy back price is locked in and if the expected return is acceptable for the investors, then the investors should be willing to invest.

3. The investor's choice depends on many factors whether there is a similar return available elsewhere in the market and whether he requires regular income from investment or just want the capital appreciation gains and the taxes applicable in the jurisdiction. Whether the long term capital gains income is exempt from tax or not. Additionally, the investor would also consider the financial strength of the both the parent (XYZ) and the subsidiary company (ABC)

4. If the US Treasury had offered an identical security, then this would have a higher price (risk free) and a lower rate of return as the default risk is minimal and the investor is almost sure of the amount at the end of the investment horizon as it is backed by the US government.