Financial Management-Chapter 7 Solution- Gitman

Topics: Bond, Bonds, Zero-coupon bond Pages: 22 (5872 words) Published: August 2, 2013
Financial Management-chapter 7 solution- Gitman

7-21

Western Money Management Inc.

Bond Valuation

Robert Black and Carol Alvarez are vice presidents of Western Money Management and codirectors of the company’s pension fund management division. A major new client, the California League of Cities, has requested that Western present an investment seminar to the mayors of the represented cities. Black and Alvarez, who will make the presentation, have asked you to help them by answering the following questions. A. Answer: What are a bond’s key features? [Show S7-1 through S7-4 here.] If possible, begin this lecture by showing students an actual bond certificate. We show a real coupon bond with physical coupons. These can no longer be issued—it is too easy to evade taxes, especially estate taxes, with bearer bonds. All bonds today must be registered, and registered bonds don’t have physical coupons. 1. Par or face value. We generally assume a $1,000 par value, but par can be anything, and often $5,000 or more is used. With registered bonds, which is what are issued today, if you bought $50,000 worth, that amount would appear on the certificate. 2. Coupon rate. The dollar coupon is the “rent” on the money borrowed, which is generally the par value of the bond. The coupon rate is the annual interest payment divided by the par value, and it is generally set at the value of rd on the day the

Chapter 7: Bonds and Their Valuation

Integrated Case

1

bond is issued. To illustrate, from Table 7-4 the required rate of return on Sprint Capital’s 2028 bonds was 6.875% when they were issued, so the coupon rate was set at 6.875%. If the company were to float a new issue today, the coupon rate would be set at the going rate today (March 2008), which would be around 10.05%—the YTM on these outstanding bonds. 3. Maturity. This is the number of years until the bond matures and the issuer must repay the loan (return the par value). 4. Call provision. Most bonds (except U.S. Treasury bonds) can be called and paid off ahead of schedule after some specified “call protection period.” Generally, the call price is above the par value by some “call premium.” We will see that companies tend to call bonds if interest rates decline after the bonds were issued, so they can refund the bonds with lower interest bonds. This is just like homeowners refinancing their mortgages if mortgage interest rates decline. The call premium is like the prepayment penalty on a home mortgage. 5. Issue date. The date when the bond issue was originally sold. 6. Default risk is inherent in all bonds except Treasury bonds—will the issuer have the cash to make the promised payments? Bonds are rated from AAA to D, and the lower the rating the riskier the bond, the higher its default risk premium, and, consequently, the higher its required rate of return, rd. 7. Special features, such as convertibility and zero coupons, will be discussed later.

2

Integrated Case

Chapter 7: Bonds and Their Valuation

B.

What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?

Answer:

[Show S7-5 through S7-7 here.] A call provision is a provision in a bond contract that gives the issuing corporation the right to redeem the bonds under specified terms prior to the normal maturity date. The call provision generally states that the company must pay the bondholders an amount greater than the par value if they are called. The additional sum, which is called a call premium, is typically set equal to one year’s interest if the bonds are called during the first year, and the premium declines at a constant rate of INT/N each year thereafter. A sinking fund provision is a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year. A sinking fund provision facilitates the orderly retirement of the bond issue. The call privilege is valuable to the firm but potentially detrimental...
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