Arnot International\'s bonds have a current market price of $1,350. The bonds ha

Question

Arnot International's bonds have a current market price of $1,350. The bonds have an 12% annual coupon payment, a $1,000 face value, and 10 years left until maturity. The bonds may be called in 5 years at 109% of face value (Call price = $1,090).

a) What is the yield to maturity? Round your answer to two decimal places. %

b) What is the yield to call, if they are called in 5 years? Round your answer to two decimal places. %

c) Which yield might investors expect to earn on these bonds, and why?

I. Investors would not expect the bonds to be called and to earn the YTM because the YTM is greater than the YTC.

II. Investors would not expect the bonds to be called and to earn the YTM because the YTM is less than the YTC.

III. Investors would expect the bonds to be called and to earn the YTC because the YTC is less than the YTM.

IV. Investors would expect the bonds to be called and to earn the YTC because the YTM is less than the YTC.

d) The bond's indenture indicates that the call provision gives the firm the right to call them at the end of each year beginning in Year 5. In Year 5, they may be called at 109% of face value, but in each of the next 4 years the call percentage will decline by 1 percentage point. Thus, in Year 6 they may be called at 108% of face value, in Year 7 they may be called at 107% of face value, and so on. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call the bonds? (in year 6, in year 7, in year 8, in year 9, bonds are always called)?

Explanation / Answer

Step-1:

Current market price = $1,350

Maturity = 10years

Coupon rate = 12%

Face value = $1,000

= $1,000*12% = $120

Bond price = coupon payment * (1-1 / 1+YTM) n) / YTM) + face value (1+YTM) n $1,350

= $120* (1-1/1+YTM) n 10 / YTM + $1,000 ( 1+YTM ) 10

YTM = 7%

Step-2:

Time period = 5years

Coupon rate = 12%

Callable price = $1,090

Coupon payment = $1,000*12% = $120

Price = coupon payment *(1-1 / 1+YTM) n) / YTM) + face value (1+YTM) n $1,350

= $120* (1-1/1+YTM) n 5 / YTM + $1,090 ( 1+YTM ) 5

Yield to call = 5%

Step-3:

Investors would expect the bond to be called and to earn the YTC bond because the YTC is less than the YTM.

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