Janice Bonds wants to invest in bonds of Evanrude Industries. The bonds were iss

Question

Janice Bonds wants to invest in bonds of Evanrude Industries. The bonds were issued 10 years ago at their $1,000 par value and have 15 years remaining until they mature. They have a 5% coupon interest rate. They are also convertible into 30 shares of common stock, and can be called any time at $1,025. The bond is rated AA+ by Bond rating agencies. Evanrude Industries acquired a small that was in financial distress. As a result of the acquisition, Bond rating agencies are considering a rate change for Evanrude bonds. Recent economic data suggest that expected inflation, currently at 3% annually, is likely to increase to a 4% annual rate.

                   Janice is still interested in the Evanrude bond but is worried about inflation, a possible rating change, and maturity risk. To evaluate the potential impact of these factors on the bond value, she decided to apply the valuation techniques she learned in her finance course.

1. If the common stock price (which the bond is convertible) rises to $50 per share after 3 years and the issuer calls the bonds at $1,025, should Janice let her bond be called or should she convert it into common stock?

2.For each of the following required returns, calculate the bond

Explanation / Answer

1. In case it is decided to let the bonds be called,

Amount received per bond = $ 1,025

In case it is decided to convert the bonds to common stock,

No. of common stock received per share = 30

Current market price per share = $ 50

Thus, amount received per bond after conversion in common stock = 30 * $50= $1,500

2. Annual coupon = 5% * 1000 = $ 50

Inflation adjusted rate of return = (1 + Required rate of return)  - 1

(1 + Inflation rate)

A simplified version of inflation adjusted rate of return = Required rate of return - Inflation rate

a) When required rate is 6%

Inflation adjusted rate of return = 6% - 4% = 2%

Bond price = 50 * PVIFA (2%,15) + 1000 * PVF (2%,15)

= $ 1,385.48

Since bond price is greater than its par value, bond is at a premium

b) When required rate is 8%

Inflation adjusted rate of return = 8% - 4% = 4%

Bond price = 50 * PVIFA (4%,15) + 1000 * PVF (4%,15)

= $ 1,111.18

Since bond price is greater than its par value, bond is at a premium

c) When required rate is 10%

Inflation adjusted rate of return = 10% - 4% = 6%

Bond price = 50 * PVIFA (6%,15) + 1000 * PVF (6%,15)

= $ 902.88

Since bond price is less than its par value, bond is at a discount

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