Case Scenario:
• Anna Hegg has been considering investing in the bonds of Atilier Industries. The bonds were issued 5 years ago at their $1000 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 at any time at $1080. Moody’s rates the bond Aa. 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 ratings change for Atilier bonds. Recent economic data suggest that expected inflation, currently at 5%pa, is likely to increase to 6% pa.
• Anna remains interested in the Atilier bond but is concerned about inflation, a potential rating change, and maturity risk. To get a feel for the potential impact of these factors on the bond value, she decided to apply the valuation techniques she learned before.
• Requirements:
Question 1: If the price of a 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 Anna let the bond be called away from her or should she convert it into common stock?
Question 2: 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.
A. Required return is 6%
B. Required return is 8%
C. Required return is 10%
Question 3: Repeat the calculations in part (2), assuming that interest is paid semi-annually and that semi-annual required returns are one-half of those shown. Compare and discuss differences between bond values for each required return calculated here and in part 2 under the annual versus semi-annual payment assumptions.
Question 4: If Anna buys the bond today at its $1000 par value and holds it for exactly 3 years, at which time the required return is 7%, how much of a gain of loss will she experience in the value of the bond (ignoring interest already received and assuming annual interest)?
Question 5: Rework part (4), assuming that Anna holds the bond for 10 years, and sells it when the required return is 7%. Compare your finding to that in part (4), and comment on the bond’s maturity risk.
Question 6: Assume that Anna buys the bond at its last price of 98.38, and holds it until maturity. What will her yield to maturity be, assuming annual interest?
Question 7: After evaluating all of the issues raised above, what recommendations would you give Anna with regard to her proposed investment in the Atilier Industries bonds?