Question

Consider

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

1) the effective yield is (100000/24500)^(1/30)-1 = 4.80%, since the effecrive interest rate is only 4.80% p.a, so that it is reasonable rate of return and hence ABC is willing to pay the same.

2) The desirability reduces as the price traded would be the fixed price discounted by market yield. that is If ABC call the bond in low-interest regime, investor has to face reinvestment risk.

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) US treasury would sell at higher price as it is a more strong borrower and hence would offer less return and hence sell at higher price

5) During the tenure of 30 years, as the time goes on, the price of the security would keep going up due to the impact of the time value of money. As the remaining tenure decreases, the total return receivable against the security also keeps going down. In other words, the difference between the price and maturity value keeps decreasing as the remaining tenure of the security decreases. Due to this reason, the price of the security would be higher today as compared to the initial price of $24,500

6) Price in 2025 will be higher than today’s price again due to the concept of time value of money and due to the fact that more returns would have accrued to the security.

Please give a thumbs up. It will help me