Question

Susan is the treasurer of ABC Property Ltd. The company needs to raise money to build a residential complex which takes 5 years to complete. The company has planned to sell the complex after completion, but has a fall back plan of renting some of the flats out should the market condition is not to their favour to sell. In general, the demand for property purchase is low during a high interest rates environment.

Currently, interest rates are relatively low and the yield curve is relatively flat. The credit spread (i.e. the risk premium for ABC to issue bond) is all time low too. Susan with a view that interest rates will stay low for a long period of time, is considering issuing a 10 year bond with one time put in year 5 in order to capture her view, as opposed to the traditional 5 year bond or 10 year bond.

a. Discuss the pros and cons of her decision. What will likely the consequence be should rates move up in 5 years’ time. (6 points)

b. Please note that I) and II) below are independent conditions:

I) The economist of the company, however, holds a different view. He believes that interest rates are likely to move up in 5 years. What type of bond will Susan likely to issue should she have to take the economist view into consideration and yet be cautious about the cost of funding. Explain. (5 points)   

II) ABC is a listed company whose board members as well as the shareholders are relatively conservative. What will Mary likely to do, should she take this into consideration? Explain. (5 points)

Answer 1

As it says that the interest rate are at all time low and spread is lowest too then it would be great to issue the bond as it will give them funds for 5/10 years at a very low interest rate. If the rate of interest moves up then the bond holders would be in search for higher interest thus exercising their put option and thus increasing risk of liquidity for the company as in ideal case where investors have option to get higher interest rate somewhere else they would all exercise put and thus company would have to pay them all the amount borrowed.

i. If she takes into consideration the views of economist then she should drop the plan to give put option in the bond and to go for a 5 year and 10 year bond as it would make sure that the funds taken for 10 years would stay with company for all those 10 years but it might reduce the subscription of the bond thus she might be forced to give a higher rate on 10 year bonds taking into some effect the increase in interest rates

ii. If the board is conservative and would like to reduce their risk then she would require to raise the fund for 10 years without any option thus satisfying her board but that might effect the subscription of the bond.