1. You are considering investing in the bonds issued by ABC Corporation. They ha
ID: 2767985 • Letter: 1
Question
1. You are considering investing in the bonds issued by ABC Corporation. They have a coupon rate of 6% and a maturity date of March 21, 2046. ABC Corp is an industrial firm and these bonds are not rated by Moody’s or S&P. The stock sells for $40 per share and pays a dividend of $ 0.15 per year. (in you answer be certain to EXPLAIN why you chose each ratio)a. As a bond investor what six ratios would you use to determine the risk level for your potential investment? b. If you were considering a one year investment by purchasing the stock of ABC instead of a bond, what three ratios would you consider most important in your decision.
Explanation / Answer
a) Times Interest earned:
It is calculated as EBIT/Interest expense. It tells how many times the EBIT will be able to pay the interest. A higher ratio indicates safety. Marginal ratios indicate riskiness.
Debt service coverage ratio:
It is calculated as EBIT/[Principal repayments/(1-t)]+Interest. It tells whether the operating profits are are sufficient to pay the principal and interest obligations. Higher the ratio, lesser the risk to the debt suppliers.
Return on Assets: Measured as EBIT/Average total assets, it indicates the basic earning power of the firm. The rate has to be higher than the interest payable on debt. Only then interest and principal payments can be made.
Debt/Equity ratio: It tells the proportion of debt to equity, thereby indicating how much financial leverage is present. A very high ratio could indicate trouble in future if the firms income declines.
Proprietary ratio, calculated as shareholder's equity/total tangible assets, it reveals the equity contribution to the assets. Higher ratio is desirable, as it indicates safety of capital to the debt holders.
Current ratio: The ratio of current assets to current liabilities, indicates whether the short term liquidity of the firm is Ok. If not the firm will be having difficulty in meeting the current obligations towards the debt.
b) Price Earnings ratio: Popularly referred to as P/E ratio, it is calculated as 'Market Price/EPS'. It is a stock market based ratio and tells as to how many times of the EPS, the investors are willing to pay for a share of the firm. It usually reveals the sentiment of the investors. If the ratio is high, it means that investors are optimistic and are expecting higher earning growth in the future and vice-versa.
ROE: Return on equity is calculated as (Net Income - preference dividend)/Equity. It tells us the rate of return earned by the firm on the funds of the common stock shareholders. This can be compared with market averages and the values of competitors.
Dividend payout ratio: Given by Dividend per share/EPS, it tells how much of the EPS is paid out as dividend. The firm's dividend/retention policy is revealed by the ratio. It tells how much of the EPS is paid out and how much is retained for growth. Investors who need dividend income can choose firms having higher payout ratios. Firm's that retain earnings may be able to provide growth.
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