32 - Bond Exercises 2023

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Western University *

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3303

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Jan 9, 2024

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1 Bond Exercises 2023 DO NOT COPY OR DISTRIBUTE/POST © IVEY BUSINESS SCHOOL In this session we will expand our understanding of coupon bonds by completing a series of numerical exercises. The primary goal is to reinforce your understanding of bond pricing mechanics. We also hope to deepen your appreciation for why firms choose different, and sometimes complex, bond terms when raising capital. We begin by considering a 6-year bond issued by Greco Corp. The bond was initially sold to investors 4 years ago as a 10-year bond. At the time it was sold at par. The face value for each bond was $1000 and the annual coupon rate was set at a fixed rate of 3.6% (coupons are paid semi-annually). You are told that currently the required return, or yield to maturity (YTM), for this bond is 4.0% APR with semiannual compounding. Discuss qualitatively how you would determine the appropriate YTM (NB – this will be the focus of our next case on WorldCom). 1. Assuming that the 4.0% APR is the correct yield, what would be the current price? 2. Suppose you bought the bond 4 years ago when first issued by the company. What rate of return would you have realized if you held the bond for 4 years and then sold it at the current price? What explains this rate of return? It turns out that Greco Corp also has a bond with 8 years to maturity outstanding. That bond also has a face value of $1000 and the annual coupon rate was set at a fixed rate of 3.2% (coupons are paid semi-annually). 3. If this bond had the same required return (YTM) as the 6-year bond, what would be its price? 4. You discover that the bond recently sold for $1,018. What is the current YTM on this bond? Does this yield make sense relative to the yield on the 6-year bond? What explanations can you offer for the YTM differences between the two Greco bonds? Finally, you hear that Greco is contemplating offering a new 6-year bond to the public, but the structure of payments proposed is quite unusual. For the first three years the bond will not pay any coupons. Starting in the fourth year (42 months from now) the bond will pay equal semi-annual coupons for the remainder of its life. The annual coupon rate from year 4 through 6 is expected to be set at 9.4%. 5. Would you expect the YTM on this bond to be above or below 4.0% (the yield on the first 6-year bond above) and why? 6. Why would Greco be considering issuing such a “step-up” bond? Greco will be selling each new bond at par value.

2 7. If the actual required return (YTM) on this bond is 4.1% (APR with semiannual compounding), would investors find it appealing? If Greco is raising 100 million in this bond offering, how much value would Greco be transferring to new investors? 8. What coupon rate should the company select if it wanted to ensure the price of the bond (at par) would be fair (neither over or underpriced)?

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