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Case Analysis on Bond Valuation

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Evaluating Annie Hegg’s Proposed Investment in Atilier IndustriesBonds.Annie Hegg has been considering investing in the bonds of AtilierIndustries, the bonds were issued 5 years ago at their P1000 parvalue and have exactly 25 years remaining until they mature. Theyhave an 8% coupon interest rate that are convertible into 50shares of common stock, and can be called anytime at P1,080. Thebond is rated Aa by Moody’s and other rating agencies areconsidering a rating change for Atilier bonds. Recent economicdata suggest that inflation currently at 5% annually, is likely to

increase to 6% annual rate.Annie remains interested in the Atilier bond but is concernedabout inflation, a potential rating change and maturity risk. Inorder to get a feel for the potential impact of these factors on thebond value, she decided to apply the valuation techniques shelearned in her finance course.

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A. If price of the common stock into which thebond is convertible rises to P30/share after 5years and the issuer calls the bond at P1080,

should Annie let the bond be called away fromher or should she convert it into common stock.

B. For each of the following required returns,calculate the bonds value, assuming annual

interest. Indicate whether the bonds will sell ata discount at a premium or at par.1) Required Return is 6%2) Required Return is 8%3) Required Return is 10%

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 C. Repeat the calculations in part b, assuming

interest is paid semi-annually and that thesemi-annual required return are ½ of those

shown. Compare and discuss differencebetween the bond values for each requiredreturn calculated here and in part b under theannual vs. semi-annual payment assumptions.

D. If Annie strongly believes that inflation will riseby 1 % during the next 6 months, what is themost she should pay for the bond, assumingannual interest?

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E. If the Atilier bonds are down-rated by Moody’sfrom Aa-A, And if such a rating change willresult in an increase in the required return from

8% to 8.75%, what impact will this have on thebond value, assuming annual interest?

F. If Annie buys the bond today at its P1,000 par

value and holds it for exactly 3 years, at whichtime the required return is 7%, how much of again/loss will she experience in the value of thebond ignoring interest already received andassuming annual interest?

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G. Rework part f, assuming that Annie holds the bondfor 10 years and sells it when the required return is7%. Compare your finding to that in part f, and

comment on the bond’s maturity risk. 

H. Assume that Annie buys the bond at its currentclosing price of 98.39 and holds it until maturity.What will her YTM be, assuming annual interest?

I. After evaluating all of the issues raised above, whatrecommendation would you give Annie with regardto her proposed investment in the Atiler Industries

bonds?

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The case is concerned about the proposal of Annie Hegg’s to invest in Atlier Industries Bonds. In all ourcomputations, we are sure that Annie Hegg’s will be ableto lay the best decision that will ensure maximum level of 

return for her. We attempted to suggest the best andsafest rates to the specific issue being brought up in thecase.

In the output, we tried to convey our solutions and

explanations of each case in the simplest way possible toensure clarity and reliability of the answers we have made.We are confident that this case analysis will be successfulbecause our computations were based on reliable andproven theories or issues that occurs concurrently with

bond investments

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A.  50 shares x P 30 per share = P 1,500

While if the bond was allowed to be called inthe value would be on P 1,080.

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B.  Current value of bond under different required returns – 

annual interest

1) Bo = I x (PVIFA6%, 25 yrs.) + M x(PVIF 6%,25 yrs.)

Bo = P 80 x (12.783) + P 1,000 x (.233)

Bo = P 1,022.64 + P 233Bo = P 1,255.64

The bond would be at a premium.

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 2) Bo = I x (PVIFA8%, 25 yrs.) + M x

(PVIF8%,25 yrs.)Bo = P 80 x (10.675) + P 1,000 x (.146)Bo = P 853.92 + P 146Bo = P 1,000.00

The bond would be at par value.

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3) Bo = I x (PVIFA10%, 25 yrs.) + M x

(PVIF10%, 25 yrs.)Bo = P 80 x (9.077) + P 1,000 x (.092)Bo = P 726.16 + P 92Bo = P 818.16

Calculator solution: P 818.46The bond would be at a discount.

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C. Current value of bond under different required returns – semiannual interest.

1) Bo = I x (PVIFA3%, 50 yrs.) + M x(PVIF3%, 50 yrs.)Bo = P 40 x (25.730) + P 1,000 x (.228)Bo = P 1,029.20 + P 228Bo = P 1,257.20

The bond would be at a premium.

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 2) Bo = I x (PVIFA4%, 50 yrs.) + M x

(PVI4%, 50 yrs.)Bo = P 40 x (21.482) + P 1,000 x (.141)Bo = P 859.28 + P 146Bo = P 1000.28

The bond would be at par value.

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 3) Bo = I x (PVIFA5%, 50 yrs.) + M x

(PVIF5%, 50 yrs.)Bo = P 40 x (18.256) + P 1,000 x (.087)Bo = P 730.24 + P 87Bo = P 817.24

The bond would be at a discount.

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D.   Bo = I x (PVIFA9%, 25 yrs.) + M x

(PVIF9%, 25 yrs.)Bo = P 80 x (9.823) + P 1,000 x (.116)Bo = P 785.84 + P 123

Bo = P 908.84

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E. Bo = I x (PVIFA8.75%, 25 yrs.) + M x(PVIF8.75%,25 yrs.)

Bo = P 80 x (10.025) + P 1,000 x (.123)Bo = P 802.00 + P 123Bo = P 925.00

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F. Bond value at 7% and 22 years to maturity.

Bo = I x (PVIFA7%, 22 yrs.) + M x(PVIF7%, 22 yrs.)Bo = P 80 x (11.061) + P 1,000 x (.226)Bo = P 884.88 + P 226Bo = P 1,110.88

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 G. Bond value at 7% and 15 years to maturity.

Bo = I x (PVIFA7%, 15 yrs.) + M x(PVIF7%,15 yrs.)

Bo = P 80 x (9.108) + P 1,000 x (.362)

Bo = P 728.64 + P 362Bo = P 1,090.64

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H. Here 983.8= I x PVIFA kd, 25 yrs. + M x PVIF kd,25 yrs.

We need to solve the equation for kd, the

YTM.TRIAL & ERROR:

Trying 9%, we get:

=I x PVIFA9%,25 yrs + M x PVIF9%,25yrs =$80 x 9.823 + $1000 x 0.116=$901.84

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Next we try for 7%I x PVIFA7%,25 yrs + M x PVIF7%,25 yrs 

=$80 x 11.654 + $1000 x 0.184= $1116.32Now LR + [(PVLR – Market Value)/ (PVLR – 

PVHR)] x [HR – LR]= 0.07 + 132.52/ 214.48 x 0.02=0.0824=8.24%

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YTM= (I +DISCOUNT/n)/ Average Price= [( 80 +(1000-983.8)/25)]/[(1000+983.8)/2]

=8.13%

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Annie Hegg should consider 8.24% as YTMfrom the bond. But if the bond are of unsecured in nature then she should consider

8.13% as YTM.

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Annie should probably not invest in the Atilier bond. Thereare several reasons for this conclusion.

1. The term to maturity is long and thus the maturity risk ishigh.

2. An increase in interest rates is likely due to the potentialdowngrading of the bond thus driving the price down.

3. An increase in interest rates is likely due to the possibility

of higher inflation thus driving the price down.

4. The price of P 983.75 is well above her minimum price of P 908.84 assuming an increase in interest rates of 1%.