Market value of bonds - calculation 12 / 13

Sample
694 others answered this question

Question 4a

Toltuck Co is a listed company in the building industry which specialises in the construction of large commercial and residential developments. Toltuck Co had been profitable for many years, but has just incurred major losses on the last two developments which it has completed in its home country of Arumland. These developments were an out-of-town retail centre and a major residential development. Toltuck Co’s directors have blamed the poor results primarily on the recent recession in Arumland, although demand for the residential development also appears to have been adversely affected by it being located in an area which has suffered serious flooding over the last two years.

As a result of returns from these two major developments being much lower than expected, Toltuck Co has had to finance current work-in-progress by a significantly greater amount of debt finance, giving it higher gearing than most other construction companies operating in Arumland. Toltuck Co’s directors have recently been alarmed by a major credit agency’s decision to downgrade Toltuck Co’s credit rating from AA to BBB. The directors are very concerned about the impact this will have on the valuation of Toltuck Co’s bonds and the future cost of debt.

The following information can be used to assess the consequences of the change in Toltuck Co’s credit rating.

Toltuck Co has issued an 8% bond, which has a face or nominal value of $100 and a premium of 2% on redemption in three years’ time. The coupon on the bond is payable on an annual basis.

The government of Arumland has three bonds in issue. They all have a face or nominal value of $100 and are all redeemable at par. Taxation can be ignored on government bonds. They are of the same risk class and the coupon on each is payable on an annual basis. Details of the bonds are as follows:

Bond Redeemable Coupon Current market value
$
1 1 year 9% 104
2 2 years 7% 102
3 3 years 6% 98
Credit spreads, published by the credit agency, are as follows (shown in basis points):
Rating 1 year 2 years 3 years
AA 18 31 45
BBB 54 69 86

Toltuck Co’s shareholder base can be divided broadly into two groups. The majority of shareholders are comfortable with investing in a company where dividends in some years will be high, but there will be low or no dividends in other years because of the cash demands facing the business. However, a minority of shareholders would like Toltuck Co to achieve at least a minimum dividend each year and are concerned about the company undertaking investments which they regard as very speculative. Shareholders from both groups have expressed some concerns to the board about the impact of the fall in credit rating on their investment.

Required:
(a) Calculate the valuation and yield to maturity of Toltuck Co’s $100 bond under its old and new credit ratings. (10 marks)

448 others answered this question

Question 3a

Levante Co has identified a new project for which it will need to increase its long-term borrowings from $250 million to $400 million. This amount will cover a significant proportion of the total cost of the project and the rest of the funds will come from cash held by the company.

The current $250 million borrowing is in the form of a 4% bond which is trading at $98•71 per $100 and is due to be redeemed at par in three years. The issued bond has a credit rating of AA. The new borrowing will also be raised in the form of a traded bond with a par value of $100 per unit.

It is anticipated that the new project will generate sufficient cash flows to be able to redeem the new bond at $100 par value per unit in five years. It can be assumed that coupons on both bonds are paid annually.

Both bonds would be ranked equally for payment in the event of default and the directors expect that as a result of the new issue, the credit rating for both bonds will fall to A. The directors are considering the following two alternative options when issuing the new bond:

(i) Issue the new bond at a fixed coupon of 5% but at a premium or discount, whichever is appropriate to ensure full take up of the bond; or
(ii) Issue the new bond at a coupon rate where the issue price of the new bond will be $100 per unit and equal to its par value.

The following extracts are provided on the current government bond yield curve and yield spreads for the sector in which Levante Co operates:

Current Government Bond Yield Curve

Year12345
3.2%3.7%4.2%4.8%5.0%

Yield spreads (in basis points)

Bond Rating  1 year2 years3 years4 years5 years
AAA59141925
AA1622304047
A657687100112
BBB102121142167193

Required:

Calculate the expected percentage fall in the market value of the existing bond if Levante Co’s bond credit rating falls from AA to A. (3 marks)

418 others answered this question

Question 3b

Levante Co has identified a new project for which it will need to increase its long-term borrowings from $250 million to $400 million. This amount will cover a significant proportion of the total cost of the project and the rest of the funds will come from cash held by the company.

The current $250 million borrowing is in the form of a 4% bond which is trading at $98•71 per $100 and is due to be redeemed at par in three years. The issued bond has a credit rating of AA. The new borrowing will also be raised in the form of a traded bond with a par value of $100 per unit.

It is anticipated that the new project will generate sufficient cash flows to be able to redeem the new bond at $100 par value per unit in five years. It can be assumed that coupons on both bonds are paid annually.

Both bonds would be ranked equally for payment in the event of default and the directors expect that as a result of the new issue, the credit rating for both bonds will fall to A. The directors are considering the following two alternative options when issuing the new bond:

(i) Issue the new bond at a fixed coupon of 5% but at a premium or discount, whichever is appropriate to ensure full take up of the bond; or
(ii) Issue the new bond at a coupon rate where the issue price of the new bond will be $100 per unit and equal to its par value.

The following extracts are provided on the current government bond yield curve and yield spreads for the sector in which Levante Co operates:

Current Government Bond Yield Curve

Year12345
3.2%3.7%4.2%4.8%5.0%

Yield spreads (in basis points)

Bond Rating  1 year2 years3 years4 years5 years
AAA59141925
AA1622304047
A657687100112
BBB102121142167193

Required:

Advise the directors on the financial implications of choosing each of the two options when issuing the new bond. Support the advice with appropriate calculations. (7 marks)