Question

Building of its reputation for manufacturing no-thrills, efficient and affordable automobiles, the Indian car manufacturers Indy Car Limited, is ready to launch an international marketing campaign, specifically targeting low- to- medium income customers in Asia and Europe. In preparation for the expected demand increase, a new production facility will be added in the state of Andhra Pradesh near Hyderabad to complement the already existing plants in Mumbai and New Delhi. The Company’s CFO, Raja Jain is planning to raise the required funds of Indian Rupees 10 billion ($222.4 million) in the form of a 20- year annual coupon paying corporate bond. The company’s current debt rating with Standard & Poor is “A” with a positive outlook, indicating the likelihood of a rating upgrade to “AA” in the near future. In that case, the market’s required rate of return could drop by as much as 75 basis points from 6.80 percent to 6.05 percent. Mr. Jain is wondering if the bond should be issued at a premium or a discount and if the company should offer a fixed or floating rate or instead of making explicit interest payments, issue a zero- coupon bond instead. Each bond will have a nominal value of Rs. 1,000. The intended issue date is 1st July 2019. You are required to: Q1. Advise Mr. Jain on the impact of the following set of bond features and characteristics on the cost of debts: sinking fund, asset backing, seniority conversion feature, differed call and make whole call provision, a put provision, and a floating rate as well as positive & a negative covenants. Q2. Compute the expected issue price based on the required rate of return of 6.8 percent for: (a). A fixed annual interest payment of Rs 64 per bond. (b). A fixed annual interest payment of Rs 72 per bond. (c). does your answer of (a) and (b) change if semi annual interest payments of Rs 32 and Rs 36 respectively, are made? If so why? (d). a zero- coupon bond Q3. Recompute your results of 2 (a), (b) and (d), assuming an upgrade in the company’s credit rating and determine the impact on the expected issue price. Q4. Explain to Mr. Jain if an affluent investor would rather buy a premium or a discount bond.

Answer 1

Q2.Expected issue price based on expected rate of return of 6.8 %

Expected rate of return (1)	0.068	0.068	0.068	0.068	0.068
Number of payments (2)	20	20	40	40	20
Coupon payments (3)	64	72	32	36	Zero
Face Values of the share (4)	1000	1000	1000	1000	1000
Expected issue price (PV(1,2,3,4))	956.96	1043.04	508.69	563.28	268.27

Expected issue price @ 64 as annual coupon payment is 956.96

Expected issue price @ 72 as annual coupon payment is 1043.04

Expected issue price @ 32 as semi annual coupon payment is 508.69

Expected issue price @ 36  as semi annual coupon payment is 563.28

Expected issue price for zero coupon bonds is 268.27

Why there is such a change ?

For me it seems mathematical , as number of coupon payments increase from 20 to 40.However , there is always a reinvestmest risk for coupon received earlier.It means an investor has to invest in a similar bond at lower yield.

Hence Bonds with semi annual coupon payments trade at lower price compared to bonds with annual coupon payments,

Q3),Recompute the prices considering upgrade in the credit rating @ 6.05 %

Rating upgrade will drop expected rate of return from 6.80 to 6.05 %

Expected rate of return (1)	0.0605	0.0605	0.0605	0.0605	0.0605
Number of payments (2)	20	20	40	40	20
Coupon payments (3)	64	72	32	36	Zero
Face Values of the share (4)	1000	1000	1000	1000	1000
Expected issue price (PV(1,2,3,4))	1039.98	1131.37	573.87	633.68	308.88

Expected issue price @ 64 as annual coupon payment is 1039.98

Expected issue price @ 72 as annual coupon payment is 1131.37

Expected issue price @ 32 as semi annual coupon payment is 573.87

Expected issue price @ 36  as semi annual coupon payment is 633.68

Expected issue price for zero coupon bonds is 308.88

Obviously with Ratings upgrade , these bonds will quote higher in the market.This is due to the fact that organization issuing bonds is more stable.

Q3:- Premium versus Discount Bond

Bond market is efficient and any bond whose interest rate is higher than market interest rate will trade at premium.Hence little / moderate premium is preferable to get more returns.Affluent investor will be more inclined towards bond selling at premium.