Activity 1.
As you know, I'm managing a bond issue for the company. This morning-the day the bond issue is to go to market-Karen, one of our investment bankers, called to let me know that two other similar issues are being marketed. Our issue is for $50 million, carrying a 5.9% coupon and a 25-year maturity. Karen recommends that we price our issue to yield 6.12%. I need to make a recommendation on how to price our issue. Since the CFO must make the final decision to proceed or not with the issue, this is of the utmost urgency.
Solution:
Apply the traditional bond valuation model in pricing the issue at the recommended market rate:
Vo = ??
What is the YTM of this bond?
You would determine that largely by reviewing the coupon rate payment. Please keep in mind that the bond face value is assumed to be the standard $1,000.
To yield X%, the bond must be discounted to price at .... This represents a $Y discount per bond. There are 50,000 bonds in the $50 million issue resulting in a cost to the firm of $xxx, definitely not a deal killer.
To determine the price of a bond, if you know the YTM and the coupon, please use either a bond financial calculator (showing all the steps) or an Excel spreadsheet and the financial function -PV. I would suggest you use the wizard within Excel, if not comfortable with this function.
Activity 2
A yellow memo pad with the following text:
We are considering purchasing a 7% percent coupon bond (coupons paid semiannually) with 14 years remaining to maturity for 102-21 (priced in 32nds). We can re-invest the coupon payments at 4% percent, and we expect to sell the bond after a 3-year holding period for 106-16 (priced in 32nds).
The beginning value (BV) is the price of the bond, 102-21 - (convert into decimal format)
The ending value (EV) consists of the future value of the coupons re-invested at 4 percent AND the expected sales price of the bond at the end of the 3-year holding period. The future value of the coupons ($3.50 semiannual) re-invested at two percent (semiannual) for six semiannual periods in the 3-year holding period is $xyz. The expected sales price is given as 106-16 (convert into decimal format). The EV is the sum of $xyz and the expected sales price, which is $YYY. Now we can input the variables into the HPY formula:
HPY = ...
If the hurdle rate is six percent, the candidate bond should be (or should not be) accepted for inclusion in the bond portfolio.