Question

As an investor, you have been considering investing in the bonds of Outdoor Fun Industries.

The bonds were issued 5 years ago at their $1,050 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 $1,180. The bond is rated Aa by Moody's. Outdoor Fun Industries, a manufacturer of patio furniture, recently acquired a family owned patio furniture store that was in financial distress. As a result of the acquisition, Moody's and other rating agencies are considering a rating change for Outdoor Fun bonds. Recent economic data suggest that inflation, currently at 5% annually, is likely to increase to a 6% annual rate.

Answer the following questions listed below.

1. 1. If price of the the common stock into which the bond is convertible rises to $35 per share after 5 years and the issuer calls the bonds at $1,180, should you let the bond be called away or should you convert it into common stock? Explain why?
2. 2. For each of the following required returns, calculate the bond's value, assuming annual interest. Indicate whether the bond will sell at a discount, at a premium, or at par value.

(a) Required return is 6%.

(b) Required return is 8%.

(c) Required return is 10%.

3. If the Outdoor Fun bonds are down rated by Moody's from Aa to A, and if such a rating change will result in an increase in the required return from 8% to 8.75%, what impact will this have on the bond value, assuming annual interest?

Answer 1

1) In this case we can convert bond into common stock to get maximum return.

Assume that $ 35 per share will earn = $1750 in total. ( $ 35 Per share for 50 Stocks), this is a great opportunity to get common stock at favourble right. As we aware the situation that Long life Low coupon bonds are risky and short life high coupon bonds are very safe so it's better to accept the commonstock offer.

2)

For calculation purpose we need below details:-

:- Value of bond

:- Maculay' s Bond Duration

:-Modified Duration

:- DV01 (Delta change of price)

Year	Bond Price	Coupon at par	DCF at par	Proportaion	Year * Proportation
1	1050	84	77.78	0.07	0.07
2	1050	84	72.02	0.07	0.14
3	1050	84	66.68	0.06	0.19
4	1050	84	61.74	0.06	0.24
5	1050	84	57.17	0.05	0.27
6	1050	84	52.93	0.05	0.30
7	1050	84	49.01	0.05	0.33
8	1050	84	45.38	0.04	0.35
9	1050	84	42.02	0.04	0.36
10	1050	84	38.91	0.04	0.37
11	1050	84	36.03	0.03	0.38
12	1050	84	33.36	0.03	0.38
13	1050	84	30.89	0.03	0.38
14	1050	84	28.60	0.03	0.38
15	1050	84	26.48	0.03	0.38
16	1050	84	24.52	0.02	0.37
17	1050	84	22.70	0.02	0.37
18	1050	84	21.02	0.02	0.36
19	1050	84	19.46	0.02	0.35
20	1050	84	18.02	0.02	0.34
21	1050	84	16.69	0.02	0.33
22	1050	84	15.45	0.01	0.32
23	1050	84	14.31	0.01	0.31
24	1050	84	13.25	0.01	0.30
25	1050	1134	165.58	0.16	3.94
			1,050.00		11.53
Maculays Duration on this bond	11.53
Modified Duration	10.67

Assume that required rate will changes, please see the below calculation

Rerquired Rate	Delta	VOB	Formula
10%	(224.17)	825.83	Delta of bond price = Change in YTM * Modified Duration * Face value
6%	224.17	1,274.17
8.75	(84.06)	965.94

3)

Bond value will comes down propationely and will be $ 965.94.

and there is hike in interest rate and it will become $ 91.88