Question

Taylor has been considering investing in the bonds of Axis Group. The bonds were issued 5 years ago at their $1,000 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. Axis Group, a manufacturer of sporting goods, recently acquired a small athletic-wear company that was in financial distress. Recent economic data suggest that expected inflation, currently at 0.66% annually, is likely to increase to a 0.11% annual rate. Taylor remains interested in the Axis Group 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.

a) If the Axis Group bonds are downrated 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 Taylorual interest?

b) If Taylor buys the bond today at its $1,000 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)?

c) Rework part (b), assuming that Taylor 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.

d) Assume that Taylor 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?

e) After evaluating all of the issues raised above, what recommendation would you give Taylor with regard to her proposes investment in the Axis Group.

Answer 1

a) If required return increases from 8% to 8.76%, Bond price(assuming annual coupon of $80)

P = 80/0.0876*(1-1/1.0876^25)+1000/1.0876^25 = $923.87

So, from Taylor's perspective, if she purchases the bond when required return was 8% (bond was trading at par value of $1000) and then required return increases from 8% to 8.76%, bond value will decrease from $1000 to $923.87

b) If the bond is sold after 3 years, at which time the required return is 7%, Price of the bond (22 years left to maturity)

P = 80/0.07*(1-1/1.07^22)+1000/1.07^22 = $1110.61

The value of the bond will increase from $1000 to $1110.61 (ignoring the coupon amounts)

c) If the bond is sold after 10 years, at which time the required return is 7%, Price of the bond (15 years left to maturity)

P = 80/0.07*(1-1/1.07^15)+1000/1.07^15 = $1091.08

The value of the bond will increase from $1000 to $1091.08 (ignoring the coupon amounts)

Note: Part f) is not given , so can't comment

d) The YTM (y) is given by

80/y*(1-1/(1+y)^25) + 1000/(1+y)^25 = 983.80

Solving for y using hit and trial method or using SOLVER tool from excel

y= 8.1538% or 8.15%