Anne Hegen

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Annie Hegg has been considering investing in the bonds of Atilier Industries. The bonds were issued 5 years ago at their P1000 par 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 P1080. 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 P30 per share after 5 years and the issuer calls the bonds at P1080, should Annie let the bond be called away from her or 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 P1000 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? 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: P 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

Calculation required for the case:

a. Call price = P1080
Call price = Face value + Interest Income
Interest Income = Call price – Face value
= P1080 – P1000
= P80

After 5 years, stock price = P(30 x 50) = P1500
If...
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