Question

Metallica Bearings, Inc. is a young start-up company. The current gearing ratio of the company is 35%, and Fitch rated the bonds issued by Metallica Bearings as BB with a face vale of £1,000 per bond. The company has £1.5m of ordinary 50 pence stocks in issue. For following five years, the UK spot rates are estimated as follows: ??1 = 0.50%, ??2 = 0.65%, ??3 = 0.70%, ??4 = 0.75%, ??5 = 1.00%. Required: a) Discuss the differences between corporate bonds and stocks.

b) Calculate the PVs of the following bonds assuming annual coupons: i) 5%, two-year bond ii) 5%, five-year bond iii) 10%, five-year bond.

c) Define YTM (yield to maturity) of bonds and evaluate the YTM on a five-year zerocoupon bond. Furthermore, explain intuitively why the yield on the five-year bonds described in part (b) must lie below the yield on a five-year zero-coupon bond.

d) In order to cope with the growth of company, no dividends will be paid for the next 5 years. The company will pay a £2 per share dividend in Year 6 and will increase the dividend by 5% per year thereafter. If an investor requires the expected return of 20% per annum on this stock, what is the share price?

Answer 1

a) Corporate bonds are fixed income securities whereas corporate stocks are equity. Fixed income securities have a fixed pay-out of coupon & principal. Equity have no fixed payout. Any dividends declared on equity are sole discretion of the shareholders of the firm and its earning. Equities are riskier than bonds & therefore have a higher expected return as compared to yield of the bonds

b)

i) 5% two-year bond

Price = 50/(1+0.5%)^1+(1000+50)/(1+0.65%)^2 = 1086.23

ii) 5% five year bond

Price = 50/(1+0.5%)^1+50/(1+0.65%)^2+50/(1+0.70%)^3+50/(1+0.75%)^4+(50+1000)/(1+1%)^5 = 1195.64

iii) 10% five year bond

Price = 100/(1+0.5%)^1+100/(1+0.65%)^2+100/(1+0.70%)^3+100/(1+0.75%)^4+(100+1000)/(1+1%)^5 = 1439.82

c)

Yield to maturity is the single rate of interest the investor earns each year if the investor hold the bond to maturity

YTM zero coupon five year bond = 1.00% (r55)

Yield of 5-year bond must be lesser as compared to zero coupon bond. This is because in a bond paying coupons annually, the payments are made each year reducing the credit risk. In a zero coupon bond, only a single payment is received at end of 5 years thus increasing the credit risk

d) Price of stock at end of year 5 = D/(Ke-g) = 2*(1+5%)/(20%-5%) = 14

Price of stock at time 0 = 14/(1+20%)^5 = 5.62