case on bond evaluation
TRANSCRIPT
Abstract of the analysis The Case is……..
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The case is concerned about Annie Hegg’s proposed investment in Atilier Industries Bonds. We solved the case with our best effort. We tried to make it sure that the investment that Annie Hegg is going to make is safe and will ensure maximum level of return for the investor. We explore the best consulting agencies portfolio to know the standard of analysis. We keep it in mind that our calculation will help someone to take a decision that would cause optimum return or optimum loss to that person. So, very precisely, we attempted to suggest the best and safest rates to the specific issues of the case. Moreover, we were aware of the optimum return that the investor should get from the investment decisions.
In the analysis, we tried to project some specific suggestions that would be helpful to the investor to invest in the concerned bond. Moreover, we let the investor know what should be his/her required rate of return though we have not been provided sufficient data regarding the market. Our analysis is specially based on the nature of the instrument, for which, the investor is going to invest handsome amount money.
Different required calculations are shown in the analysis to make it more authentic and reliable. The analysis will be successful if it can serve the purpose of the investors i.e. not only to secure the optimum return but also to understand the reasons behind the decisions and their proper implementation in practical field.
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Client Profile Case to be resolved
Name: Annie Hegg
Profession: Student
(Major: Finance)
Annie Hegg has been considering investing in the bonds of Atilier Industries. The bonds were issued 5 years ago at their $1000 per 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 $1080.the bond is rated Aa by Moody’s. Atilier Industries, a manufacturer of sporting goods, recently acquired a small athletic-wear company that was in financial distress. As a result of the acquisition, Moody’s and other rating agencies are considering a rating change for Atilier bonds. Recent economic data suggest that the inflation, currently at 5% annually, is likely to increase to a 6% annual rate.
Annie remains interested in the Atilier bond is concerned about inflation, a potential rating change, and maturity risk. In order to get a feel for the potential impact of these factors on the bond value, she decided to apply the valuation techniques she learned in her financial course.
Required
a. If price of the common stock into which the bond is convertible rises to $30 per share after 5 years and the issuer calls the bonds at $1080, should Annie let the bond be called away from her should she convert it into common stock?
b. 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.
1) Required return is 6%
2) Required return is 8%
3) Required return is 10%
c. Repeat the calculation in part b, assuming that interest is paid semiannually and that the semiannual required returns are one-half of those shown. Compare and discuss differences between the bond values for each required return calculated here and in part b under the annual versus semiannual payment assumption.
d. If Annie strongly believes that inflation will rise by 1% during the next 6 months, what is the most she should pay for the bond, assuming annual interest?
e. If the Atilier 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?
f. If Annie buys the bond today at its $1000 per value and holds it for exactly 3 years, at which time the required return is 7%, how much of a gain or loss will she experience in the value of the bond (ignoring interest already received and semiannual interest)?
g. Rework part f, assuming that Annie holds the bond for 10 years and sells it when the required return is 7%. Compare your finding to that in part f, and comment on the bond’s maturity risk.
h. Assume that Annie buys the bond at its current closing price of 98.38 and holds it until maturity. What will her yield to maturity (YTM) be assuming annual interest?
i. After evaluating all of the issues rose above, what recommendation would you give Annie with regard to her proposed investment in the Atilier Industries bonds?
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Investing concern: Atilier Industries
Investment instrument: Bond
Nature of the investment instrument: Debt secured or unsecured
First came in the market: 5 years ago
Remaining life time: 25 years
Coupon interest rate: 8%
Call-on price: $ 1080
Conversion rate: 50 shares per bond
Rating of the bond: Aa by Moody’s.
Merger with: A small athletic-wear company
Special information: The rating of the company Is going to be changed since Moody & other rating agencies have already started working.
Existing Inflation rate: 5%
Possible change in the inflation rate: +1%
Related risk identified: 1. Inflation
2. A potential rating change
3. maturity risk
Special feature: Call-on option, convertible
bond
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Calculation required for the caseA.
Call price =$1080
We know,
Call price = Face value+ interest (Extra payment to the
bond holder)
Interest Income = Call Price-Face Value
= $ 1080 - $ 1000
= $ 80
After 5 years,
Stock price = $ (30 × 50) = $1500
If she sells the stock at the end of the 5th year, then she will get
Income from sale of Stock= $ (1500-1000)
= $500
ANALYSIS At the end of 5th year, Stock Price > Call Price
DECISION Bonds should be converted into common stock
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B.
1. When RRR = 6%,
BO = I × PVIFA 6%, 25yrs + M × PVIF 6%, 25yrs
= $ 80 × 12.783 + $ 1000 × 0.233
= $ 1255.64
2. When RRR = 8%,
BO = I × PVIFA 8%, 25yrs + M × PVIF 8%, 25yrs
= $ 80 × 10.675 + $ 1000 × 0.146
= $ 1000
3. When RRR = 10%,
BO = I × PVIFA 10%, 25yrs + M × PVIF 10%, 25yrs
= $ 80× 9.077 + 1000 × 0.092
= $ 818.16
Table 1: Analysis and Decision
Coupon Interest Rate (CIR)
Required Rate of Return (RRR)
BO Par Value Analysis Decision
8% 6% $ 1255.64 $1000 RRR< CIR Premium
8% 8% $ 1000 $1000 RRR= CIR At Par
8% 10% 818.16 $1000 RRR> CIR Discount
6% 8% 10%
0
200
400
600
800
1000
1200
1400 1255.64
1000
818.16
Bond Value ($)
Graph 1: Bond value at different RRR
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C.
1. BO = [I÷2] × PVIFA 6%/2, 25×2yrs + M × PVIF 6%/2, 25×2 yrs
= [80÷2] × 25.730 +1000 × 0.228
=$ 1257.20
2. BO = [I÷2] × PVIFA 8%/2, 25×2yrs + M × PVIF 8%/2, 25×2 yrs
= 40 × 21.482 + 1000 × 0.141
= $ 1000.28
3. BO = [I÷2] × PVIFA 10%/2, 25×2yrs + M × PVIF 10%/2, 25×2 yrs
= 40 × 18.256 + 1000 × 0.087
= $ 817.24
Table 2: Annual versus Semiannual payments
Graph 2: Annual versus Semiannual payments
D.
6%8%
10%
$0.00
$200.00
$400.00
$600.00
$800.00
$1,000.00
$1,200.00
$1,400.00 1255.64
1000
818.16
1257
1000.28
817.24
Annual
Semi-annual
Annually RRR Semiannually
$ 1255.64 6% $ 1257.20
$ 1000 8% $ 1000.28
818.16 10% $ 817.24
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To solve the problem, we must consider the fisher effect on the RRR since correlation between RRR & inflation has not been given.
Here,
The coupon interest rate is 8%,
So the real rate= (8-5) %
=3%
Therefore, the inflation adjusted rate of return should be:
R = (1+0.03) × (1+0.06)-1
=9.18%
BO = I × [(1+і) ⁿ - 1⁄і× (1+і) ⁿ] + M × [1÷
(1+і) ⁿ]
= $80 [(1+.0918)25-1⁄.0918×
(1+.0918)25] + $ 1000[1⁄ (1+.0918)25]
= 718.8979 – 97.8891 + 111.2814
= $ 732.2902
Moreover, it is a common tradition that investors calculate their
E.
For 8%,
BO = $ I × PVIFA 8%, 25yrs+ M × PVIF 8%, 25yrs
= $ 80 × 10.675 + $ 1000 × 0.146
The Fisher Effect defines the relationship between real rates, nominal rates and inflation
• (1 + R) = (1 + r) (1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
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= $ 1000
For 8.75%,
BO = I × [(1+і) ⁿ - 1⁄і× (1+і) ⁿ] + M × [1÷ (1+і) ⁿ]
= $80 [(1+.0875)25-1⁄.0875× (1+.0875)25] + $ 1000[1⁄ (1+.0875)25]
= $ 921.2068
Here the RRR (8.75%) is greater than CIR (8%), so the BO ($ 921.2068) is less than its par
value ($1000).
F.
When, n = (25 – 3) yrs = 22yrs
BO = I ×PVIFA 7%, 22yrs + M ×PVIF 7%, 22yrs
= $ 80 × 11.061 + $ 1000 × 0.226
Down rated from
Aa to A
Higher Default
Risk
Higher Premium
Higher RRR
Greater Obligation
Less Liquidity
Higher Need of Working Capital
Higher Cost of Debt
Higher Cost of Capital
Figure 2: Effect of down rated from Aa to A
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= $ 1110.88
M = $ 1000
Gain = BO – M
= $1110.88 – $ 1000
= $ 110.88
G.
When, n = (25 – 10) yrs = 15yrs
BO = I × PVIFA 7%, 15yrs + M × PVIF 7%, 15yrs
= $ 80 × 9.108 + $ 1000 × 0.362
= $ 1090.64
M = $ 1000
Gain = BO – M
= $ 1090.64 - $ 1000
= $ 90.64
F GMaturity Period: 3 < 10
Maturity Risk: Lower Higher
Reason: The longer the maturity, the more the value of a security will change in response to a given change in interest rates.
H.
Here 983.8 = I × PVIFA kd, 25yrs + M × PVIF kd, 25yrs
We need to solve the equation for kd, the YTM.
Trial & Error:
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Because we know that a required return, kd, of 8% would result in a value of $ 1000, the premium rate that would result in $ 983.8 may be greater or less than 8%.
Trying 9%, we get
I × PVIFA 9%, 25yrs + M × PVIF 9%, 25yrs
= $ 80 × 9.823 + $ 1000 × 0.116
= $ 901.84
Next we try for 7%,
I × PVIFA 7%, 25yrs + M × PVIF 7%, 25yrs
= $ 80 × 11.654 + $ 1000 × 0.184
= 1116.32
Now LR + [(PVLR – Market Value)/ (PVLR – PVHR)] × (HR – LR)
= 0.07 + 132.52/ 214.48 × 0.02
= 0.0824 = 8.24%
Direct Formula:
YTM = (I + Discount/ n) /Average Price
= [(80 + (1000 – 983.8)/25)]/ [(1000+ 983.8)/ 2]
= 8.13 %
Decision: Annie Hegg should consider 8.24% as YTM from the bond. But if the bond are of unsecured in nature then she should consider 8.13% as YTM.
I.
We recommend Annie Hegg to invest if and only if:
1. The situation mentioned here remains unchanged.2. Required rate of return Is satisfactory to the investor. When a required return
on a bond differs from the bond’s coupon interest rate, the bond’s value will
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differ from its par value. The required return is likely to differ from the coupon interest rate because either:
Economic conditions changes. The firm’s risk changes.
So, Annie should take care of both these factors.3. Inflation adjusted required rate of return is sufficient to fulfill the demand of
the investor.4. Bond should b converted into stock when market price of the stock is such
that conversion will provide a profit to the bond holder.5. When Annie will decide to sell the bond she must forecast her gain and loss.
Here premium and discount r important factors. She should analyze that whether the sale is in premium or in discount. IF,Bonds value > Market value then the sale is in premiumBonds value < Market value then the sale is in discount.
6.The credit quality of most issuers and their obligations is not fixed and steady over a period of time, but tends to undergo change. For this reason changes in ratings occur so as to reflect variations in the intrinsic relative position of issuers and their obligations.
A change in rating may thus occur at any time in the case of an individual issue. Such rating change should serve notice that Moody's observes some alteration in creditworthiness, or that the previous rating did not fully reflect the quality of the bond as now seen. While because of their very nature, changes are to be expected more frequently among bonds of lower ratings than among bonds of higher ratings. Nevertheless, the user of bond ratings should keep close and constant check on all ratings — both high and low — to be able to note promptly any signs of change in status that may occur.
So, Annie must make herself sure about the bond rating factor as it exerts much impact incase of investment in bonds. We may help her by providing the following bond rating chart:
Moody’s and Standard & Poor’s Bond Ratings:
Moody’s Interpretation Standard & Poor’s InterpretationAaa Prime equality AAA Bank investment
qualityAa High grade AAA Upper medium A
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gradeBaa Medium grade BBBBa Lower medium
gradeBB Speculative
B Speculative BCaa From very
speculative CCC
Ca To near or in default
CC
C Lowest grade C Income bondD In default
7.If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return. So, she should also analyze the default risk as well.
8.She should be concern about interest rate risk, whether it is rising or not because a rise in interest rates, and therefore in the required return , cause a decrease in bond’s value.
In fine, we should say that, our calculation in the different sections of this analysis depicts the true picture of the total investment scenario in the concerned issue. Therefore, investors can easily change the decision complying with the changed situation just having a glimpse on the analysis we have forwarded.