Chapter 1 Discounted Cash Flow Techniques

Chapter 3 Financing Decision

Answer 1

(a)

In order to calculate the duration of the two bonds, the PV of the annual cash flows and the price or value at which the bonds are trading at need to be determined. To determine the PV of the annual cash flows, they need to be discounted by gross redemption yield.

Gross Redemption Yield (GRY)

GRY = [2]

Bond 1

Duration = 4,845.35 / 1,079.68 = 4.49 years[3]

Bond 2

Duration = 4,587.02 / 991.15 = 4.63 years[4]

(b)

The sensitivity of bond prices to changes in interest rates is dependent on their redemption dates. Bonds which are due to beredeemed at a later date are more price-sensitive to interest rate changes, and therefore are riskier.

Duration measures the average time it takes for a bond to pay its coupons and principal and therefore measures the redemptionperiod of a bond. It recognises that bonds which pay higher coupons effectively mature ‘sooner’ compared to bonds whichpay lower coupons, even if the redemption dates of the bonds are the same. This is because a higher proportion of the highercoupon bonds’ income is received sooner. Therefore these bonds are less sensitive to interest rate changes and will have alower duration.

[3 – 4 marks]

Duration can be used to assess the change in the value of a bond when interest rates change using the following formula:

ΔP = [-D x Δi x P] / [1 + i], where P is the price of the bond, D is the duration and i is the redemption yield.

However, duration is only useful in assessing small changes in interest rates because of convexity. As interest rates increasethe price of a bond decreases and vice versa, but this decrease is not proportional for coupon paying bonds, the relationship isnon-linear. In fact the relationship between the changes in bond value to changes in interest rates is in the shape of a convexcurve to origin, see below.

[2 – 3 marks]

Duration, on the other hand, assumes that the relationship between changes in interest rates and the resultant bond is linear.Therefore duration will predict a lower price than the actual price and for large changes in interest rates this difference can besignificant.

Duration can only be applied to measure the approximate change in a bond price due to interest changes, only if changes ininterest rates do not lead to a change in the shape of the yield curve. This is because it is an average measure based on thegross redemption yield (yield to maturity). However, if the shape of the yield curve changes, duration can no longer be used toassess the change in bond value due to interest rate changes.

[2 – 3 marks]

(c)

Industry risk

Industry risk refers to the strength of the industry within the country and how resilient it is to changes in thecountry’s economy. Industry risk could be assessed using such factors as the impact of economic forces onindustry performance, the cyclical nature of the industry (and the extent of the peaks and troughs) and theextent to which industry demand is affected by economic forces.

Earnings protection

Earnings protection refers to how well the industry will be able to protect its earnings in the wake of changesin the economy. This could be assessed using such factors as diversity of the customer base, sources offuture earnings growth and profit margins and return on capital.

Financial flexibility

Financial flexibility refers to the ease with which companies can raise finance in order to pursue profitable investmentopportunities. This could be assessed by evaluating future financial needs, the range of alternative sources offinance available, the company’s relationship with its bank and any debt covenants that may restrict operations.

Evaluation of the company’s management

This refers to how well management is managing the company and planning for its future. This could beassessed by looking at the company’s planning, controls, financing policies and strategies; merger andacquisition performance and record of achievement in financial results; the overall quality of managementand succession planning.

[2 marks for each criteria]

Answer 2

(a)

[1]

Expected bond value at A rating – to be redeemed in 3 years’ time

Bond value (A rating) = [1]

Expected percentage fall in the market value = [1]

(b)

Financial implications of each of the two options

(i)Value of 5% bond

Spot rates applicable to Levante Co are those calculated above:

Value of 5% fixed coupon bond:

=

[1]

Hence the bond will need to be issued at a discount if only a 5% coupon is offered.

(ii)New coupon rate for bond valued at $100 by the market

Take R as the coupon rate, such that:

4.2826R + 74.30 = 100

R = 6%[4]

Advise to directors

If only a 5% coupon is offered, the bonds will have to be issued at just under a 4·3% discount. To raise the full$150 million, if the bonds are issued at a 4·3% discount, then 1,567,398 $100 bond units need to be issued, as opposedto 1,500,000. This is an extra 67,398 bond units for which Levante Co will need to pay an extra $6,739,800 when thebonds are redeemed in five years.

On the other hand, paying a higher coupon every year of 6% instead of 5% will mean that an extra interest of $1,500,000 ($9m– $7.5m) is neededfor each of the next five years.

If the directors feel that the drain in resources of $1,500,000 every year is substantial and that the project’s profits will coverthe extra $6,739,800 in five years’ time, then they should issue the bond at a discount and at a lower coupon rate. On theother hand, if the directors feel that they would like to spread the amount payable then they should opt for the higher couponalternative.

[2 – 3 marks]

(c)

Industry risk

Industry risk refers to the strength of the industry within the country and how resilient it is to changes in thecountry’s economy. Industry risk could be assessed using such factors as the impact of economic forces onindustry performance, the cyclical nature of the industry (and the extent of the peaks and troughs) and theextent to which industry demand is affected by economic forces.

Earnings protection

Earnings protection refers to how well the industry will be able to protect its earnings in the wake of changesin the economy. This could be assessed using such factors as diversity of the customer base, sources offuture earnings growth and profit margins and return on capital.

Financial flexibility

Financial flexibility refers to the ease with which companies can raise finance in order to pursue profitable investmentopportunities. This could be assessed by evaluating future financial needs, the range of alternative sources offinance available, the company’s relationship with its bank and any debt covenants that may restrict operations.

Evaluation of the company’s management

This refers to how well management is managing the company and planning for its future. This could beassessed by looking at the company’s planning, controls, financing policies and strategies; merger andacquisition performance and record of achievement in financial results; the overall quality of managementand succession planning.

(d)

Here:

F = 1,050

π= (25 × 12)/1,050 = 0.286

S = 0

L = 400/1,050 = 0.381

Interest = (250×0.04) + (150×0.05) = 17.5

C = 450/17.5 = 25.7

σ= 0.08

[3]

Y = 4.41 + (0.0014 × 1,050) + (6.4 × 0.286) – 0 – (2.72 × 0.381) + (0.006 × 25.7) – (0.53 × 0.08)

Y = 4.41 + 1.47 + 1.830 – 1.036 + 0.154 – 0.042 = 6.79[2]

The Kaplan-Urwitz model predicts that the credit rating will be AAA.[1]

A3-1