Stephan and Chris have decided to acquire CellU in order to expand TechU’s produ

Question

Stephan and Chris have decided to acquire CellU in order to expand TechU’s product line. They are trying to decide how to finance the acquisition, and are currently looking at financing it by issuing bonds. They want to examine their existing bond issues to get an overall picture of their debt financing, and since they will have to pay off CellU’s bonds after the acquisition, they are reviewing those also. Help Stephan and Chris by answering the following questions.

1.) TechU just issued an 18-year, 12 percent coupon bond for $1,165.47. What is the current yield on this bond? What is the yield to maturity?

2.) TechU is also thinking about issuing five hundred 20-year, zero-coupon bonds. The market interest rate is 12 percent. What is the value of each of these bonds?

Explanation / Answer

1)

Current yield is the bond’s annual return based on its annual coupon payments and current price.

It is computed using the following formulas:

Current yield=Annual coupons/Current bond price

=$120/$1165.47

=10.29%

Yield to maturity:

YTM=[Interest + Current price-Face value/Number of years to maturity]/ (Current price-Face value)2

={120+(1165.47-1000)/18}/(1065.47+1000)/2

=9.984%

2)

Market value of zero coupon bonds issued:

=Number of bonds*face value*discount factor for 20 years at 12% rate

=500*1,000* 0.103667

=$51,833

Thus, the market value of zero coupon bonds is $51,833.

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