Financial Management Accounting

Western Money Management Inc.

Group Case # 4
October 20, 2018

Submitted to:
Felix D. Cena, CPA, PhD

Submitted by:
GROUP 1
Camato, Kevin
Feria, Hanah
Gatoc, Dorothy
Jereza, Jose Martin Jacob
Lucero, RG
Tanongtanong, Janice

Saturday, 2:00PM – 5:00 PM

a. What are the key features of a bond?

The following are the key features of a bond:

1. Par Value or Face Value- is the money amount the bond will be worth at its maturity,
and is also the reference amount the bond issuer uses when calculating interest
payments. For example, say an investor purchases a bond at a premium $1,090 and
another purchases the same bond at a discount $980. When the bond matures, both
investors will receive the $1,000 face value of the bond.
2. Coupon Interest Rate- is the rate of interest the bond issuer will pay on the face value
of the bond, expressed as a percentage. For example, a 5% coupon rate means that
bondholders will receive 5% x $1000 face value = $50 every year.
3. Maturity- is the date on which the bond will mature and the bond issuer will pay the
bond holder the face value of the bond.
4. Issue price- is the price at which the bond issuer originally sells the bonds.
5. Coupon dates- are the dates on which the bond issuer will make interest payments.
Typical intervals are annual or semi-annual coupon payments.

b. What are call provisions and sinking fund provisions? Do these provisions make bonds
more or less risky?
A call provision is a provision on a bond or other fixed-income instrument that
allows the original issuer to repurchase and retire the bonds. If there is a call provision in
place, it typically comes with a time window under which the bond can be called, with a
specific price to be paid to bondholders, and any accrued interest defined within the
provision. On the other hand, sinking fund call is a provision allowing a bond issuer the
opportunity to buy outstanding bonds from bondholders at a set rate, using money (a
sinking fund) from the issuer's earnings saved specifically for security buybacks. Because
it adds doubt for investors over whether the bond will continue to pay until its maturity date,
a sinking fund call is seen as an additional risk for investors.

Since the bond can be called at any time during the agreed-upon time period, the
risk exists that the investor will lose the long-term benefits of holding the bond if the call
provision is exercised. While the investor will not lose any money in terms of the amount
originally invested, the investor does lose the future interest payments that would have
been due had the bond been held until maturity. If the investor chooses to reinvest the
funds in another bond, he may not be able to secure an interest rate comparable to the
one held previously.
 A sinking fund call reduces credit risk since the fund implies that provision to repay
the debt has been provided for and, therefore, payment obligations are secured. However,
sinking funds have the potential to depreciate given that they can underperform in a slow
economy.

c. How is the value of any asset whose value is based on expected future cash flows
determined?
The value of an asset is merely the present value of its expected future cash flows:

d. How is the value of a bond determined? What is the value of a 10-year, $1000 par value
bond with a 10 percent annual coupon if its required rate of return is 10 percent?
The price of a bond is determined by discounting the expected cash flow to the
present using a discount rate. The discount rate used is the yield to maturity, which is the
rate of return that an investor will get if s/he reinvested every coupon payment from the
bond at a fixed interest rate until the bond matures. It takes into account the price of a
bond, par value, coupon rate, and time to maturity.
bFV= $1000 n= 10 yrs CR= 10% MR= 10%

PVb= PMT (PVIFAi, n) + [PMT= 1000 0.1= $100]

PVb= 100 (PVIFA 10%, 10) + [PVIFA 10%, 10 = 6.1446]

PVb= 100 (6.1446) + 385.5

PVb= $999.96

e. 1. What would be the value of the bond described in part d if, just after it had been
issued, the expected inflation rate rose by 3 percentage points, causing investors to
require a 13 percent return? Would we now have a discount or a premium bond?
FV= $1000 MR= 13% n= 10 yrs CR= 10%

PVb= PMT (PVIFAi, n) + [PMT= 1000 0.1= $100]

PVB= 100 (PVIFA 13%, 10) + [PVIFA13%, 10= 5.426]

PVB= 100 (5.426) + 294.6
PVB= $837.2

It can be noted that the value of the bond decreases. We now have a discount bond
because the present value of the bond is below its par value.
2. What would happen to the bond’s value if inflation fell, and kd declined to 7
percent? Would we now have a premium or a discount bond?
FV= $1000 MR= 7% n= 10 yrs CR= 10%

PVB= PMT (PVIFAi, n) + [PMT= 1000 0.1= $100]

PVB= 100 (PVIFA 7%, 10) + [PVIFA7%, 10= 7.0236]

PVB= 100 (7.0236) + 508.3

PVB= $1,210.70

This time, the value of the bond increases. We now have a premium bond because the present
value of the bond is above its par value.

3. What would happen to the value of the 10-year bond over time if the required
rate of return remained at 13 percent, or if it remained at 7 percent? (Hint: With a
financial calculator, enter PMT, I, FV, and N, and then change (override) N to see what
happens to the PV as the bond approaches maturity.)
FV= $1000 MR= 13% n= 10 yrs CR= 10%

PVB= PMT (PVIFAi, n) + [PMT= 1000 0.1= $100]

PVB= 100 (PVIFA13%, 10) + [PVIFA13%, 10= 5.426]

PVB= 100 (5.426) + 294.6

PVB= $837.20

As the bond is a discount bond the value of the 10-year bond will increase over time, if
the required rate of return remained at 13%, till it reaches maturity.

FV= $1000 MR= 7% n= 10 yrs CR= 10%

PVB= PMT (PVIFAi, n) + [PMT= 1000 0.1= $100]

PVB= 100 (PVIFA7%, 10) + [PVIFA7%, 10= 7.0236]

PVB= 100 (7.0236) + 508.3

PVB= $1210.7

As the bond is a premium bond the value of the 10-year bond will decrease over time, if
the required rate of return remained at 7%, till it reaches maturity.
f. 1. What is the yield to maturity on a 10-year, 9 percent annual coupon, $1000 par
value bond that sells for $887.00? That sells for $ 1134.20? What does the fact that a
bond sells at a discount or at a premium tell you about the relationship between kd and
the bonds coupon rate?

FV= $1000 n= 10 yrs CR= 9% MV= $887.00

YTM= [C= 1000 0.09 =90]

YTM= 0.1074 = 10.74%

FV= $1000 n= 10 yrs CR= 9% MV= $1134.20

YTM= [C= 1000 0.09 =90]

YTM= = 0.0718 = 7.18%

The market rate (kd) is higher than the coupon rate for a bond that sells at a discount
and the market rate (kd) lower than the coupon rate for a bond that sells at a premium.

2. What are the total return, the current yield, and the capital gains yield for the
discount bond? (Assume the bond is held to maturity and the company does not default
on the bond.)
Total return= required rate of return= 10.74%

Current Yield= 0.1015= 10.15%

Capital gains/loss yield= 100

= 100

= 11.3%

g. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual
payment 1-year bond or a 10-year bond? Why?
Interest rate (or price) risk: The risk of a decline in a bond’s price due to an increase in
interest rates.
A 10-year bond has more interest rate risk because the longer the maturity of the bond,
the more its price changes in response to a given change in interest rates. Suppose you bought a
10-year bond that yielded 10% or $100 a year. Now suppose interest rates on comparable risk
bonds rose to 15%. You would be stuck with only $100 of interest for the next 10 years. On the
other hand, had you bought a 1-year bond, you would have a low return for only 1 year. At the
 end of the year you would get your $1000 back and you could then reinvest it and receive 15% or
$150 per year for the next 9 years. So risk is higher for 10-years bond.

h. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond
or a 10-year bond?

Reinvestment rate risk: The risk that a decline in interest rates will lead to a decline in
income from a bond portfolio.

A 1-year bond has more reinvestment rate risk because shorter the maturity of a bond,
the lower the years when the relatively high old interest rate will be earned and sooner the funds
will have to be reinvested at the new low rate.

i. How does the equation for valuing a bond change if semi-annual payments are made?
Find the value of a 10-year, semi-annual payment, 10 percent coupon bond if nominal
kd = 13%.

FV= $1000 MR= 6.5% n= 20 yrs CR= 10%

PVB= PMT (PVIFAi, n) + [PMT= = $50]

PVB= 50 (PVIFA6.5%, 20) + [PVIFA6.5%, 20= 11.032]

PVB= 50 (11.032) + 283.8

PVB= $835.40

j. Suppose you could buy, for $1000, either a 10 percent, 10-year annual payment bond
or a 10 percent, 10-year semi-annual payment bond. They are equally risky. Which
would you prefer? If $1000 is the proper price for the semi-annual bond, what is the
equilibrium price for the annual payment bond?

SEMI ANNUAL SHOULD BE PREFFERED.

M 2
 r   0.10 
1. EAR =  1  NOM   1   1    1  10.25%.
 M   2 
2. It is better than 10.0%
3. The equilibrium price for the annual payment would be $984.80
4. While the semi-annual bond is 1,000
k. Suppose a 10-year, 10 percent semiannual coupon bond with a par value of $1000 is
currently selling for $1135.90, producing a nominal yield to maturity of 8 percent.
However, the bond can be called after 4 years for a price of $1050.

1. What is the bond’s nominal yield to call (YTC)?

5. N = 8; PV = -1,135.90; PMT = 50; and FV = 1,050
6. I/YR=3.568%
7. rNOM = 2(3.568%) = 7.137% = 7.1%

2. If you bought this bond, do you think you would be more likely to earn the YTM
or the YTC? Why?
We are more likely to earn the YTC because if the going rate remains at YTM= 8%
then the company could save 10% 8%= 2% or $20 per bond per year by calling them and
replacing the 10% bonds with a new 8% issue. There would be cost to the company to
refund the issue but the interest savings would probably be worth the cost. So the
company would probably earn YTC= 7.18% rather than YTM= 8%.

l. Does the yield to maturity represent the promised or expected return on the bond?
As the bond is being called back, the bondholder no longer gets the promised
payments to maturity, in which case the calculated yield to maturity will be the expected
return on the bond.

m. These bonds were rated AA- by S&P. Would you consider these bonds investment grade
or junk bonds?
The bond investment are Investment Grade Bonds because these bonds are rated
higher than triple-B.

n. What factors determine a company’s bond rating?

1. Financial performance—debt, TIE, and current ratios.
2. Qualitative factors—Bond contract terms:
 Secured vs. unsecured debt
 Senior vs. subordinated debt
 Guarantee provisions
 Sinking fund provisions
 Debt maturity
3. Miscellaneous qualitative factors:
 Earnings stability
 Regulatory environment
 Potential product liability, labor problem and antitrust issues
 Pension liabilities
o. If this firm were to default on the bonds, would the company be immediately
liquidated? Would the bondholders be assured of receiving all of their promised
payments?
1. whether the value of the reorganized firm is likely to be greater than the value of the
firm’s assets if they were sold off.
2. If the firm is deemed to be too far gone to be saved, it will be liquidated and the priority
of claims (as seen in Web Appendix 7C) would be as follows:
 Secured creditors.
 Trustee’s costs.
 Expenses incurred after bankruptcy was filed.
 Wages due workers, up to a limit of $2,000 per worker.
 Claims for unpaid contributions to employee benefit plans.
 Unsecured claims for customer deposits up to $900 per customer.
 Federal, state, and local taxes.
 Unfunded pension plan liabilities.
 General unsecured creditors.
 Preferred stockholders, up to the par value of their stock.
 Common stockholders, if anything is left.
3. But if the firm is worth more “alive” then “dead”, the stockholder would take a big hit
and they would not receive the promised payments.