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International Financial Management Perpetual Bond
Semester Fourth 2011Instruction: Answer ALL questions. Marks will be awarded for good presentation and thoroughness in your approach. NO marks will be awarded for the entire assignment if any part of it is found to be Copied directly from printed materials or from another student. complete this cover sheet and attach it to your assignment.
Total number of pages including this cover page.
Submission Date
10-05-2011 Due Date 10-05-2011
Student's ID 51,15,28 Course Name International Financial Managment
Student's Full Name
Masood Sadiq, Waheedullah Khan, Adeel Sittar
Lecturer's Name
Mr. Syed Tauqeer Ahmad
COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 1
Student declaration:
I declare that: I understand what is meant by plagiarismThe implication of plagiarism have been explained to me by my institutionThis assignment is all my own work and I have acknowledged any use of the published or unpublished works of other people.
Student's signature: Masood Sadiq, Waheedullah khan, Adeel Sittar
Date: 10-05-2011
COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 2
Table of contentIndex Explanation Page No.
1 Title Page 1
2 Bissmillah 2
3 Table of Content 3
4 Introduction to perpetuity bond 4
5 How to calculate perpetual bond 4-5
6 Risk 5-6
7 Capital Requirement 6
8 Advantages 6-8
9 Disadvantages 8
10Comparing Perpetual Bond Common Stock &
Preferred Stock
9-11
11 Conclusion 11
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Perpetual Bond OR Console BondA bond with no maturity date. Perpetual bonds are not redeemable but pay a steady stream of
interest forever. Some of the only notable perpetual bonds in existence are those that were issued
by the British Treasury to pay off smaller issues used to finance the Napoleonic Wars
(1814). Some in the U.S. believe it would be more efficient for the government to issue perpetual
bonds, which may help it avoid the refinancing costs associated with bond issues that have
maturity dates. In case of liquidation creditors and depositors pay first and second pay bond
holders.
A perpetual bond is also known as a 'consol' issued by the UK Government
Examples of perpetuity:
Local governments set aside monies so that funds will be available on a regular basis for
cultural activities.
A children’s charity club set up a fund designed to provide a flow of regular payments
indefinitely to needy children.
How to calculate perpetuity?
According to book “business formulas” that perpetual bond are that have no maturity date, for
computing the yield on the perpetual bond is
I/P OR coupon rate* face value
Market yield
I = interest rate
P = market value of the bond
For Example:
Bond P has a $1,000 face value and provides an 8% annual coupon. The appropriate discount
rate is 10%. What is the present value of the perpetual bond?
COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 4
I = $1,000 ( 8%) = $80.
kd = 10%.
V = I / kd [Reduced Form]
= $80 / 10% = $800.
Example: Assume a $1000 face value perpetual bond with a market price of $950 paying $120 in
annual interest what is the yield of the bond.
120/950= 0.1263=12.63%
Example: Alan wants to retire and receive $3,000 a month. He wants to pass this monthly
payment to future generations after his death. He can earn an interest of 8% compounded
annually. How much will he need to set aside to achieve his perpetuity goal?
Solution: R = $3,000
i = 0.08/12 or 0.00667
Substituting these values in the above formula, we get
$3000
A ∞ = ---------
0.00667
= $449,775
If he wanted the payments to start today, we must increase the size of the funds to handle the first
payment. This is achieved by depositing $452,775 which provides the immediate payment of
$3,000 and leaves $449,775 in the fund to provide the future $3,000 payments.
Risks
Fixed-rate securities are subject to interest rate risk because a bond's market price is
inversely related to interest rates. When prevailing market interest rates are high, bond
COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 5
prices decline. Conversely, if market interest rates are low, bond prices rise. The idea is if
market interest rates are high, bond investors would rather get a higher return on newly
issued bonds featuring the prevailing higher interest rates. Some other risks include
credit, prepayment, reinvestment, volatility and yield curve risk.
Capital Requirements
Perpetual bonds are typically sold by banks, which generally retain the right to call them after
five years. They rank as Tier 1 capital and help lenders fulfill their capital requirements.
What Does Tier 1 Capital Mean?
A term used to describe the capital adequacy of a bank. Tier I capital is core capital; this includes
equity capital and disclosed reserves.
Investopedia explains Tier 1 Capital
Equity capital includes instruments that can't be redeemed at the option of the holder.
Advantages
Anyway, the main advantage for the issuer is that capital that it doesn't have to pay back is
considered equity, and can be leveraged. This is of great value, as it allows a company to have a
bigger operation without having to raise equity by issuing stock. Issuing stock would dilute the
value of stock held by current investors. The main disadvantage is that payment of the interest is
mandatory, whereas a company doesn't have to pay a dividend. However, in some bonds, the
company can defer the payment of the interest when it doesn't pay a dividend. It's like stock, only
it doesn't carry voting rights.
A second major advantage is the fact that most of these issues offer the right, but not the
obligation, for the company to redeem the bond, by paying it back. In other words, the company
has a call warrant on the bond, and the owner of the bond is short that warrant. The terms for this
COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 6
call vary; often, it may only be exercised in a few years, and then for instance once a year. The
company might exercise this call if it can find cheaper money elsewhere - perhaps a regular
bond, or a perpetual bond with a lower interest rate. Of course, it doesn't have to do this; if the
current arrangement is cheaper, it will just keep it. In practice, this means the company will
redeem when interest goes down, and will keep the bond when it goes up.
So, in other words, the person buying this bond doesn't know when he will get his money back
and isn't even sure of an interest payment if it's linked to the dividend. Worse, the investor is
pretty much guaranteed that he will get his money back when interest is lower, so he won't be
making as much as he would have when holding the bond. If the interest were to skyrocket, the
investor would rather have the money and invest it somewhere else where it would yield even
more interest. So, why would anyone buy this faux stock?
The reason is interest. The interest on these products is often very high for several reasons:
The duration is long. Long-dated bonds are much more risky than short-dated bonds; this
is reflected in a higher interest rate.
The interest a company has to pay is higher that a government has to pay, because the
company can default. This effect is amplified by the long duration of the bond, especially
for a company that might be quite solvent now, but may not be in a decade or two.
The call option the issuer has is valuable, and the investor has to be compensated.
Often, these bonds are subordinated. This means that should the company default, other
bondholders get paid first. In practice, this more likely than not means that a default
means your entire investment is gone.
For products such as these, receiving 2-3% more interest than a 10-year government bond is
probably the lower limit an investor should accept. The payment should initially never be less
than the dividend, either, as the dividend should go up in the long run, while the interest won't.
Often, these products are tradable. It is worth noting that in this case, the interest is computed
over the value of the principal, not the price one pays. For instance, imagine a perpetual 8% bond
is trading at 70 Euros with a principal of 100 Euros. In this case, 1000 Euros buys roughly 14
COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 7
bonds, which pay 1400 * 8% = 112 Euros of interest, or 11.2%. Should the company decide to
pay back its bonds, it will pay 1400 Euros, making the investor another 40%.
As discussed, this product is rather risky for an investor to hold. The main risks are:
Market risk. The price of the bond can fluctuate in the market. If the investor is under no
pressure to sell, this in itself doesn't really matter, as the interest stream doesn't change.
Market risk for an interest rate increase. If the interest rate goes up, it would be relatively
better to invest in other bonds. This will manifest in the price of the bond. If you are a
private investor, you will probably find this a bit annoying; for a professional player who
may have bought the bond with borrowed money, the immediate loss in the bond price
hurts. As a very rough rule of thumb, a percentage point of interest rate increase may
depress the value of the bond by about 5 to 10% (although I can think of many
exceptions).
Market risk for an interest rate decrease. This will move up the price of the bond-by just a
little. While the perpetual bond becomes a better investment relative to other bonds,
leading to a price increase, the effect is minor as it becomes very likely the issuer will
redeem the bond.
Default risk. If the market thinks the issuer will default, the value of the perpetual bond
will drop very fast. Of course, if the company actually defaults, the entire investment is
gone.
Disadvantages
bond will never yield a huge profit for a short period of time
Investor cannot decide to hold bond until maturity to receive a lump sum payment
Treated as equity not debt
Similar to low volatility stock that pays dividends
As one can see, there are many reasons for the price of the bond to go down, while there is very
limited potential for it to go up. This is compensated for by the high fixed return. In fact, for
COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 8
modest price drops, say caused a 1% increase in interest rate, this return is so high that the
investor is still breaking even.
Comparing Perpetual Bond Common Stock &
Preferred StockStocks and bonds remain the most common and easily accessible forms of investing available to
personal investors. There are options that exist for both stocks and bonds with perpetual bonds,
common stocks and preferred stocks being the three most sought-after investment vehicles,
because they are the most readily available, and the initial investment for all three is attainable
for even the smallest of investors.
1. Types
o A perpetual bond has no maturity date, which means the bond and the investment
will remain in effect until the bond holder decides to liquidate the bond. Investors
prefer perpetual bonds for their stability and longevity. Investing in a perpetual
bond is a long-term form of investing.
Common stock is the stock and shares of ownership issues by a company that is
public. A public company sells shares of the company to investors and in return
the company reports on business performance on a routine basis. Common stock
owners also receive dividends on stock shares, which is a division of business
profits.
Preferred stock is similar to common stock, but the main difference is that
preferred stock holders are paid dividends before common stock owners.
2. Features
o The most noticeable feature of a perpetual bond is stability in the investment.
Market fluctuations do not affect perpetual bonds once the investment has been
COMSATS INSTITUTE OF INFORMATION TECHNOLOGY, VEHARI Page 9
made. The bond continues to earn the same rate of interest and return as it did
when the bond was initially purchased. Low-risk investors prefer this feature.
Common and preferred stocks are moderate to high-risk investments that allow
investors to be actively involved in investing. Buying, holding and selling stock is
a way that investors can change their return on investment. For example, holding
shares of stock in a company where the stock price does not change much offers
moderate-risk investor the ability to maintain her financial position. Higher-risk
investors can move in and out of stocks quickly if they choose to.
3. Benefits
o The primary benefit of perpetual bonds is the low risk associated with them.
Perpetual bonds have a lower interest rate associated with them compared to other
forms of investing; however, this is a benefit for an investor who does not want to
risk his investment.
The main benefit of common and preferred stocks is the opposite of perpetual
bonds. Market fluctuations and constant stock price changes provide investors
with the opportunity to increase their earnings through buying stocks at a low
price and selling them at a higher price. There is more involvement and
understanding on the end of the investor as monitoring stock holdings and
knowing when to sell is the key to recouping your initial investment plus making
a profit.
4. Potential
o The potential of perpetual bonds in terms of investment strategy is that income is
routine and forever, which means that gauging income received from the bond is
easy to calculate and market conditions will not affect what the investor receives
as income.
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Stocks, both common and preferred, have the potential to earn investors large
gains in income if the stocks are selected carefully and thus bought and sold at the
right time. The potential exists to make investments in stocks that provide returns
on investment of 100 percent to 200 percent. Stocks, both common and preferred,
issued during an IPO (initial public offering) hold the greatest potential in terms
of large gains being made.
5. Warning
o Perpetual bonds should be used as a long-term, low-risk strategy. A warning for
investors is to make sure that perpetual bonds are not their only form of
investment. Due to the lower rate of return, investors will maintain their current
investment amount while making a slight income on revenue. Stocks, both
common and preferred, should be invested in cautiously as stock prices can not
only rise, but also fall.
ConclusionIn summary, a perpetual bond is a bond that doesn't have to pay back by the issuer, but does pay
a fixed interest. In this, it is a bit like a share and a bit like a normal bond. Its risk is between that
of a share and a normal bond. As it is a fairly complex product with a pretty asymmetric risk
profile, it's best for advanced investors. The bond market is deep and offers investors a variety of
bonds to purchase. Besides fixed-rate securities, investors can invest in inflation-linked bonds,
floating rate notes, zero coupon bonds and perpetual bonds that have no maturity. A state or local
government issues municipal bonds. The benefit of these bonds is that the interest payments are
exempt from federal taxes and the taxes from the issuing state.
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