Question

Again, King Solomon is interested in buying a bond issued by Zenzo Pharma Ltd. Zenzo Pharma intends to use the proceeds of the bonds to finance the production of its new vaccine for COVID 19. The bond has a face value of GH¢10,000 at a coupon rate of 12% and a term to maturity of 10 years. The bond expects to pay coupons annually. Included in the bond indenture are call and sinking fund provisions. The required rate of return on the market for bonds with similar features is 18% per annum. Your boss had asked you to advice King Solomon based on the information he provided.

Explain to King Solomon what call provisions and sinking fund provisions are and how these provisions are expected to affect the risk of the bond.

Which value will you place on a bond of Zenzo Pharma Ltd

Answer 1

Call Provision

It is a contingent provision which is included in the bond indenture. It gives a right to the issuer of the bond to call back the bond when the interest rates are falling. Due to this early retirement risk is faced by the investor. Investor faces a interest rate risk as falling interest rates wont benefit investor to such an extent as the bond is callable.

Sinking Fund provision

It is a strategy used by issuer to reduce certain amount of debt each year. Every year certain amount of debentures shall be repaid. Investor actually is not aware whose debentures are going to be repaid. Hence again there is uncertainity which surrounds the investment and suffers from early retirement of the bonds. At the time of falling interest rates this is negative impact on the investors.

We find the value of the bonds using financial calculator

N = 10, FV = 10000, PMT = 1200 IY = 18

Compute PV we get 7303.55