Question

Fortescue Metals Group issued 5% per annum bonds on 12 August 2014 that mature on 12 August 2030. The par value of each bond is $1,000. The interest on these bonds is paid, and compounded, annually. The bonds are callable on 12 August 2025 at 115% of par value. Due to the risk profile of Fortescue Metals Group, investors required a 10% per annum rate of return when these bonds were first issued.

a)    Determine the value of Fortescue Metals Group’s bonds, when they were first issued, if investors did not expect these bonds to be called.

b) Determine the value of Fortescue Metals Group’s bonds, when they were first issued, assuming investors expected them to be called on the future call date.

c)Three years after issuance, these bonds are currently trading at a value of 40 cents on the dollar ($400). If you currently require a return of 14% on investments of this perceived risk level, should you buy these bonds as of 12 August 2017? In your answer, please ensure you explain in one sentence why you believe these bonds will be called or not.

Answer 1

Part (a):

Value, on the date of issue, if investors do not expect the bond to be called= $608.81

Part (b):

Value, on the date of issue, if investors expect that the bond called on the future call date= $727.82

Details of calculation as follows:

Part (c):

Three years after issue, with a selling price of $400 per bond, yield is as follows:

Yield to Maturity (YTM)= 16.452781%

Yield to Call (YTC)= 22.762987%

Since the yield in either scenario is higher than the minimum required 14%, it can be bought.

Since the YTC is higher than YTM, the bond will not be called.

Computation of YTM and YTC as follows: