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. Mary 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. (10 points)

b. ABC is a listed company whose board members as well as the shareholders are relatively conservative. In view of this, her colleague is suggesting to issue a 10 year bond and callable in 5 years. Mary has the concern of the cost as the coupon rate for traditional callable bond is likely to be higher than a straight 10 year bond. Name two alternatives for Susan to alleviate her concern. (6 points)

c. What will Mary likely to do eventually? Explain. (4 points)

Answer 1

A) Since the interest rates are falling down and assumed to be low, issuing bonds would be an appropriate option. Since relative cost of bonds would be more cheaper options instead of going for equity financing. Bonds would reflect a uniform coupon payments which would eventually favourable for companies having a long term profitable project prospects. Since the bonds have a embedded put option, the bond holders have the right to redeem the bonds at the particluar price. If the interest rates would be rising the bondholders would redeem the bonds and company would have to reissue bonds at a higher interest rates having high financing cost for the companies.

B) The price of the callable would be higher instead of a straight bond because of the call option embedded in the bond. A callable bond gives the right to the company to call the bonds at a predetermined price. Hence bond holders are compensated with higher bond yields. When the interest rates falls, calllable bonds would make company to call the bonds and issued at a lower interest rates.

C) Mary can evaluate the market scenario pertaining to interest rate stability and forecasting and therefore take a decision to issue a callable bonds or straight bond.