Question

Suppose a large firm seeks to raise capital by issuing a bond at the beginning of 2017 with a $5,000 face value and $250 coupon payments to be made at the end of 2017, 2018, 2019, and 2020. The corporation will also repay the principle amount of the bond back to investors at the end of 2020\.

1. What is the rate of interest that the firm is paying on its bonds?

2. If Moody’s decides to upgrade the firm’s debt rating, what will be the likely result for the interest rate the firm will have to pay when it sells bonds?

3. Briefly explain. If the discount rate is 2%, what is the present value of the bond?

4. If the discount rate increases, then what will happen to the present value of the bond?

5. If a new risk-free investment pays an interest rate of 5 percent what would happen to demand for the firm’s bonds?

Answer 1

1.

Rate of interest paid = coupon payment / face value

Rate of interest paid = 250/5000

Rate of interest paid = 5%

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2.

With upgrade of the ratings, the credibility of the bond will increase. It will cause coupon payment to decrease. So, the seller will pay less interest rate to the buyers.

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3.

If R = 2%

Then,

Present value of the bond = 250*(1-1/(1+R)^4)/R + 5000/(1+R)^4

Present value of the bond = 250*(1-1/(1+2%)^4)/2% + 5000/(1+2%)^4

Present value of the bond = $5571.16 or $5571

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4.

There is an inverse relationship between discount rate and present value of the bond. When discount rate increases, then present value of the bond decreases.

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5.

If other risk free investments pay the interest rate of 5%, then demand for this risk free investment will increase as it is risk free. As a result, demand for the firm's bond will decrease as it is a bond issued by a private firm and it has risk attached to it. So, unless the interest rate increases to be more than 5%, the demand of firms bond decreases.