Higher effective rate of interest

Question 1. In the past, Abbott Labs had two bond issues outstanding with the following characteristics:

Issue    Interest Rate    Maturity    Current Price
A    6%    2008    115
B    6%    2012    118

a) Which issue, A or B, has the higher effective rate of interest? How can you tell?

b) Assume that the bonds of both issues have face values of $1,000 each. How much total interest does each bond from issue A provide investors in 12 months? How much total interest does each bond from issue B provide investors in 12 months?

c) Note that both issues are by the same company, have the same contract rate of interest, and have identical credit ratings. In view of these facts, explain the current price difference of each issue.

Question 2. ADM Labs is a publicly owned company with several issues of capital stock outstanding. Over the past decade, the company has consistently earned modest profits and has increased its common stock divided annually by 5 or 10 cents per share. Recently the company introduced several new products that you believe will cause future sales and profits to increase dramatically. You also expect a gradual increase in long-term interest rates from their present level of about 11 percent to perhaps, 12 percent to 12¼ percent.

On the basis of these forecasts, explain whether you would expect to see the market prices of the following issues of ADM capital stock increase or decrease. Explain your reasoning in each answer.

a) 10 percent, $100 par value preferred stock (currently selling at $90 per share).

b) $5 par value common stock (currently paying an annual dividend of $2.50 and selling at $40 per share.)

c) 7 percent, $100 par value convertible preferred stock (currently selling at $125 per share).

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Finance Basics: Higher effective rate of interest
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