Question

RST Plc is a stock exchange listed manufacturing company. Following a decision made by the board to expand its manufacturing facilities, the company needs to raise additional finance amounting to $120 million by way of a five year corporate bond issue. The proposed corporate bond will have a par value of $100 and will be redeemed at this par value at the end of year five. Existing funds were raised by way of a ten year bond which matures in three years’ time. The existing bond has a coupon rate of 4.75% and a nominal value of $100. The bond will be redeemed at this nominal value three years’ time from now and coupon payments are made annually. There will be sufficient funds to redeem the existing bond. The issue will significantly change the company’s capital structure and as such, the credit rating will fall from the current AAA to A. the company’s treasurer has been advised that this is still within the investment grade. Five government bonds are in issue, bond 1, bond 2, bond 3, bond 4 and bond 5. Each bond has a par value of $100 and is redeemable at the par value upon maturity. Coupon payments on each bond are made annually.

The following additional information is available in respect of each bond:
Bond Maturity term Annual coupon rate Price
Bond 1 1 year 3.25% $99.90
Bond 2 2 years 3.75% $98.75
Bond 3 3 years 3.85% $97.80
Bond 4 4 years 4.15% $96.50
Bond 5 5 years 4.20% $96.10

In addition, the following table showing the credit spreads applicable to the sector in which RST Plc operates has been obtained from a credit rating agency:
Credit spreads in basis points

Credit Rating 1 year 2 years 3 years 4 years 5 years
AAA 20 30 40 50 60
AA 45 55 64 76 82
A 52 62 73 85 96

The following proposals have been made in respect of the proposed bond issue:

Proposal A
Issue the proposed corporate bond with a fixed annual coupon rate of 6%, with the first coupon payment being made at the end of year 1.

Proposal B
Issue the proposed corporate bond with an annual fixed coupon rate of 4% from year 1 to year 3 and a fixed annual coupon rate of 7% from year 4 to year 5.

Proposal C
Issue the proposed corporate bond at an annual fixed coupon rate but such that the issue price will be equal to the bond’s par value of $100.

Proposal D
Issue the proposed corporate bond with a variable annual coupon rate based on the Bank Base rate so that the annual coupons will be Bank Base Rate + 40 basis points.

Required:

(a) Calculate the percentage decrease in the market value of the existing bond arising from the decrease in credit rating from AAA to A.

(b) Calculate whether the proposed bond would be issued at a discount or at a premium if the terms of issue were:
(i) Those in proposal A
(ii) Those in proposal B

(c) Calculate what the fixed annual coupon rate would be if the proposed bond was issued based on the terms of proposal C.

(d) Explain why a company may consider issuing a bond based on the terms stated under proposal B.

(e) Discuss the problems that are likely to be faced by the company if the proposed bond was issued based on the terms of proposal D.

Answer 1

a). Yields of govt bonds:

Yield of corporate bond at AAA rating = 5-year govt bond yield + credit spread

= 5.10% + 0.6% = 5.70%

Yield of corporate bond at A rating = 5-year govt bond yield + credit spread

= 5.10% + 0.96% = 6.06%

Current price of existing bond issue at AAA rating: FV = 100; PMT (annual coupon payment) = coupon rate*par value = 4.75%*100 = 4.75; N (number of remaining payments) = 3; rate (calculated yield) = 5.70%, solve for PV.

Current market price at AAA rating = 97.44

Current price of existing bond issue at A rating: FV = 100; PMT (annual coupon payment) = coupon rate*par value = 4.75%*100 = 4.75; N (number of remaining payments) = 3; rate (calculated yield) = 6.06%, solve for PV.

Current market price at AAA rating = 96.49

Decrease in market price = decrease in price/existing price = (97.44-96.49)/97.44 = 0.97%

b). Proposal A:
FV = 100; PMT = 6%*100 = 6; N = 5; rate = 6.06%, solve for PV.

Issue price = 99.73 Since this is less than the par value of 100, Proposal A bond is issued at a discount.

Proposal B:

Current price = sum of present values of all future cash flows

= 4/(1+6.06%) + 4/(1+6.06%)^2 + 4/(1+6.06%)^3 + 7/(1+6.06%)^4 + (7+100)/(1+6.06%)^5 = 95.93

Proposal B is also issued at a discount.

c). For the issue price to be equal to the par value, the yield has to be equal to the coupon rate so for Proposal C, the annual coupon rate will be 6.06%.

d). If the company is not a good financial situation at present and also, anticipates that there may not be enough investors for the proposed bond issue, it could go for Proposal B where in the annual coupon rate is lower for the first 3 years and then, increases when the company could be better placed to pay the higher coupon.

e). If the annual coupon rate is based on the bank base rate then the risk is that if the base rate increases, annual coupon payments will go up. In such a situation, the company might find it difficult to make the annual payments and could face bankruptcy.