Question 5 (20 Marks) Two firms are each offering investors the opportunity to i

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Question 5 (20 Marks) Two firms are each offering investors the opportunity to invest in their corporate bonds. The bonds have 3 years to maturity and are available at par value. The face value of each bond is $1,000 and they pay annual coupon payments. Details are below pon l Price Per annum 6.00% 6.20% Firm A Firm B $1020 (Immediately) Required: a) Suppose that market interest rates decline by 80 basis points (0.8%). Contrast the effect of this decline on the price of each bond. Explain in detail. State all (8 marks) b) Should you prefer Firm A or Firm B bonds when rates are expected to rise or to fall? Explain your choice. State all assumptions. (5 marks) c) How does operating leverage give firms greater sensitivity to business cycles? What is portfolio sector rotation? Give examples of rotation into appropriate industries according to different stages of business cycles. (7 marks)

Explanation / Answer

a) there are two kind of bonds which are collable and noncollable. Non-collable bonds are those bonds which have fixed maturity date and can't be called back if the interest rate fluctuate. Whereas the collable bonds are those bonds who don't have a fixed maturity date and called back by firm whenever required hence change in interest rate have important role in this. In given case as Firm A is non collable and have the interest rate risk because here the rate is booked for a fixed interval until it matures. In this case the firm A is definitely not in benefit bcs will pay higher interest rate comparing to what market offers whereas the Firm B has the option to call back the bonds by paying premium to the investors and reissue the security at present rate as it is suitable for the firm (less cost of capital). Here, there is one more thing, firm is exposed to reinvestment risk because the less interest might not attract the investors and the firm unable to get the investors for same.

Also,in this case if firm A finds that it is paying high cost then it can go to redeem the same by paying some penalty. But the question is will go for it if it finds that paying penalty will also keep the firn in win situation.

B)case1: Investment and decision is always depends upon the risk appetite od the investors, lets assume I have less appetite towards risk and looking for some fixed rate of return on my investment hence I would like to go for Firm A reason being it provides me assurity towards a fixed income.

Case 2: High risk high return, callable bonds give high risk and high return to the investors as it seems it pays 6.20% in comparison to the other bond which is higher. Also, there is risk that in case the interet rate reduces the firm will call back the secutity for reinvesting purpose which end up to no future income for the investors.

C) Operating leverage occurs when a company has a fixed cost which it bears wether sales of the firm are favourable or not. Operating leverage is high in case of companyhas high proportion fixed operating cost and vice versa. Having high leverage gives immense benefit to the firm since firm already has a good set up increase in ales need not to reinvest in purchasing more fixed asset again to continue the process. Degree of operating leverage (DOL) is use to measure the sensitivity of the firm's opearting income and also to reflect its cost structure. If cost structure is higher it would be tough to manage the short term fluctuations in the sales part of the company. Conversely, the low degree (DOL) shows that the company can manage the ups and downs in the sales part as it is not having the high risk of paying back opearing cost.

Also, operating leverage helps in analysing company's risk profile. High operating leverage gives a company both benefits and increase the risk factor as well as explained above. For eg., considering any internet company started long back and invested a good amount in operating assets, it would have been definitely helpful for them as this sectors has risen immensely.

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