Question

ABC Aviation Corporation, a subsidiary of XYZ Aviation Corporation, sold some securities to the public on June 15, 2017. The securities were bought and sold on the New York Stock Exchange. The terms of the deal are as follows:

• Promise to repay the owner of one of these securities $100,000 on June 15, 2047
• The securities DO NOT pay interest
• ABC has the right to buy back the securities on the anniversary date at a price established at the time of sale
• Investors paid ABC $24,500 for each of these securities

• Why would ABC be willing to accept such a small amount today ($24,500) in exchange for a promise to repay approximately 4 times that amount in the future?
• What impact does the buyback feature have on the desirability of the investment?
• Would you be willing to pay $24,500 in exchange for $100,000 in 30 years?   What would be your key consideration in answering yes or no?
• If the U.S. Treasury had offered basically identical security, do you think it would have a higher or lower price? Why?
• If you looked at the New York Stock Exchange price of the stock TODAY, do you think the price would exceed the $24,500 original price? Why?
• If you looked in the year 2025, do you think the price would be higher or lower than today's price? Why?

Answer 1

ABC is willing to accept such a small amount today (i.e. $24,500) in exchange for a promise to repay approximately 4 times that amount in the future mainly due to the concept of time value of money. This is because the future value of money = amount*(1+r)^n. In this case future value will be 24,500*(1+r)^30 [30 means 30 years and June 15, 2047 to June 15, 2017 is 30 years]. Thus 24,500*(1+r)^30>100,000. Solving this we get r>4.8% to accumulate an amount in excess of $100,000. ABC can do this easily by investing its money wisely into a mix of equity and debt to earn more than 4.8% per annum.

The buyback feature will reduce the desirability of the investment. This is because market value of the security will get reduced due to the provision of the buyback and the security will be traded at the established price as reduced by the market yield for the duration of time to maturity of the security.

I will be willing to pay $24,500 in exchange for $100,000 in 30 years depending on certain factors. Firstly the rate of return that is implicit in the security should be attractive when compared to other investments of similar nature. Secondly the risk element of the investment should be reasonable. This will depend on who makes the promise to pay.

The US Treasury security will have a higher price because of the simple reason that the risk associated with securities offered by US Treasury has the lowest risk element in the market. US Treasury is the most powerful borrower and hence its security will have no risk of default.

The price in New York Stock Exchange today will exceed the $24,500 original price as some of the returns till date would have accumulated on the stock.

Price in 2025 will be higher than today’s price again due to the concept of time value of money and due to the fact that more returns would have accrued to the security.