In: Accounting
Kaufman enterprises has bonds outstanding with a $1,000 face value and 10 years left until maturity. They have an 11% annual coupon payment, and their current price is $1,175. The bonds may be called in 5 years at 109% of face value (Call price = $1,090). a. What is the yield maturity? b. What is the yield to call if they are called in 5 years? c. Which yield might investors expect to earn on these bonds? Why? d. The bonds’ indenture indicates that the call provision gives the firm the right to call the bonds at the end of each year beginning in Year 5. In Year 5, the bonds may be call at 109% of face value; but in each of the following 4 years, the call percentage will decline by 1%. Thus, in Year 6, they may be called at 108% of face value; in year 7, they may be called at 107% of face value; and so forth. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call the bonds?Include a detailed explanation of the conclusion you reached concerning whether or not to call the bond before maturity. If your recommendation is to call the bond early, explain when to call the bond and your rationale.
a. Yield to maturity: Yield to maturity is the total return an investor can anticipate on bond if the bond is held until maturity. It is an annual rate or internal rate of return an investor can anticipate if the bond is held until maturity and all the payments (coupon and principal) are made as scheduled.
YTM = C + F-P
N
F+P
2
Where
C = Coupon payment
F = Face Value
P = Price
N = years to maturity
YTM = 8.35%
b. Yield to call: Yield to call is a measure of return of a bond if an investor is holding it until the call date
Yield to call = Annual return + Call Price – Market Price
Numbers of years to call
Call Price + Market Price
2
= 110 +1090-1175
5
1090+1175
2
= 110-17
1132.5
= 8.2%
c. The bonds are selling at premium that means the interest rates have fallen down since the bonds were actually issued. Assuming that the interest rate will remain the same, the investor would expect to earn yield to call.
d. YTC for the subsequent years (as calculated above)
Year 6: YTC = 8.27%
Year 7: YTC = 8.37%
Year 8: YTC = 8.46%
Year 9: YTC = 8.54%
According to these calculations, the investor might expect the firm to call the bond latest by Year 6 as the YTC is less then the expected YTM in this year and the firm has the advantage to call the bond rather to hold it to maturity.