Question

Ann has been considering investing in the bonds of ABC Berhad. The bonds were issued 5 years ago at their RM1,000 par value and have exactly 25 years remaining until they mature. They have an 8% coupon interest rate, are convertible into 50 shares of common stock and can be called any time at RM1,080. The bond is rated AA by RAM. ABC Berhad, a manufacturer of sporting goods, recenty acquired a small athletic-wear company that was in financial distress. As a result of the acquisition, RAM and MARC are considering a rating change for ABC Berhad bonds. Recent economic data suggest that expected inflation, currently at 0.66% annually, is likely to increase to a 0.11% annual rate. Ann remains interested in the ABC Berhad bond but is concerned about inflation, a potential rating change, and maturity risk. To get feel for the potential impact of these factors on the bond value, she decided to apply the valuation techniques she learned in her finance course.

To do:

a. If the price of the common stock into which the bond is convertible rises to RM12 per share after 5 years and the issuer calls the bonds at RM1,080, should Ann let the bond be called away from her or should she convert it into common stock?

b. For each of the following required returns, calculate the bonds value, assuming annual interest. Indicate whether the bond will sell at a discount, at a premium, or at par value.

1. Required return is 6%

2. Required return is 8%

3. Required return us 10%

c. Repeat the calculation in part (b), assuming that interest is paid semiannually and that the semiannual required returns are one-half of those shown. Compare and discuss differences between the bond values for each required return calculated here and in part (b) under the annual versus semiannual payment assumptions.

d. If Ann strongly believes that expected inflation will rise by 1% during the next few months, what is the most she should pay for the bond, assuming annual interest?

e. If the ABC Berhad bonds are downrated by RAM from AA to A, and if such a rating change will result in an increase in the required return from 8% to 8.76%, what impact will this have on the bond value, assuming annual interest?

f. If Ann buys the bond today at its RM1,000 par value and holds it for exactly 3 years, at which tie the required return is 7%, how much of a gain or loss will she experience in the value of the bond (ignoring interest already received and assuming annual interest)?

g. Rework part (f), assuming that Ann holds the bond for 10 years and sells it when the required return is 7%. Compare your finding to that in part (f), and comment on bond’s maturity risk.

h. Assume that Ann buys the bond at its last price of 983.80 and holds it until maturity, what will her yield to maturity (YTM) be, assuming annual interest?

i. After evaluating all of the issues raised above, what recommendation would you give Ann with regard to her proposes investment in the ABC Berhad

Answer 1

a). If the callable bond is converted into shares after 5 years then amount recived would be 50*12 = 600.

This is much lower than the call price of 1,080 so Ann should not convert to common shares and she should let the bond be called.

b). Annual coupon rate is 8%, so

1). Required return of 6% < 8%, so price will be higher than par value. Bond will trade at a premium.

Bond value: FV (par value) = 1,000; PMT (annual coupon) = coupon rate*par value = 8%*1,000 = 80; N = 25; rate = 6%, solve for PV. Bond price = 1,255.67

2). Required return of 8% = 8%, so price will be equal to the par value. Bond price = 1,000

3). Required return of 10% > 8%, so price will be lower than par value. Bond will trade at a discount.

Bond value: FV (par value) = 1,000; PMT (annual coupon) = coupon rate*par value = 8%*1,000 = 80; N = 25; rate = 10%, solve for PV. Bond price = 818.46

c). Semi-annual coupon rate will be 4% so

1). Required return of 3%

Bond value: FV (par value) = 1,000; PMT (semi-annual coupon) = coupon rate*par value = 4%*1,000 = 40; N = 25*2 = 50; rate = 3%, solve for PV. Bond price = 1,257.30

2). Required return of 4%. This is same as semi-annual coupon rate so bond will still be priced at 1,000.

3). required return of 5%

Bond value: FV (par value) = 1,000; PMT (semi-annual coupon) = coupon rate*par value = 4%*1,000 = 40; N = 25*2 = 50; rate = 5%, solve for PV. Bond price = 817.44

d). If inflation rises by 1% then bond price would be

Bond value: FV (par value) = 1,000; PMT (annual coupon) = coupon rate*par value = 8%*1,000 = 80; N = 25; rate = 9%, solve for PV. Bond price = 901.77

She should not pay more than 901.77 for the bond.