Chapter 3 Financing Decision
Answer 1
(a)
In order to calculate the duration of the two bonds, the PV of the annual cash flows and the
price or value at which the bonds are trading at need to be determined. To determine the PV
of the annual cash flows, they need to be discounted by gross redemption yield.
Gross Redemption Yield (GRY)
Year
0
Market value
1–5
Interest
5
Capital payment
Cash flow
DF
PV
DF
PV
($)
4%
($)
5%
($)
(1,079.68)
1.000
(1,079.68)
1.000
(1,079.68)
60
4.452
267.12
4.329
259.74
1,000
0.822
822
0.784
784
9.44
GRY = 4% 
(35.94)
9.44
 (5%  4%)  4.2%
9.44  35.94
[2]
Bond 1
1
$
Cash flows
Discount at 4.2%
Present value
x by year
60
0.960
57.58
1
57.58
2
$
60
0.921
55.26
2
110.52
3
$
60
0.884
53.03
3
159.10
Duration = 4,845.35 / 1,079.68 = 4.49 years
4
$
60
0.848
50.90
4
203.58
5
$
1,060
0.814
862.91
5
4,314.57
Total
$
1,079.68
4,845.35
[3]
Bond 2
A3-1
Cash flows
Discount at 4.2%
Present value
x by year
1
$
2
$
40
0.960
38.39
1
38.39
40
0.921
36.84
2
73.68
3
$
40
0.884
35.36
3
106.07
Duration = 4,587.02 / 991.15 = 4.63 years
4
$
40
0.848
33.93
4
135.72
5
$
1,040
0.814
846.63
5
4,233.16
Total
$
991.15
4,587.02
[4]
(b)
The sensitivity of bond prices to changes in interest rates is dependent on their redemption
dates. Bonds which are due to be redeemed at a later date are more price-sensitive to interest
rate changes, and therefore are riskier.
Duration measures the average time it takes for a bond to pay its coupons and principal and
therefore measures the redemption period of a bond. It recognises that bonds which pay
higher coupons effectively mature ‘sooner’ compared to bonds which pay lower coupons,
even if the redemption dates of the bonds are the same. This is because a higher proportion of
the higher coupon bonds’ income is received sooner. Therefore these bonds are less sensitive
to interest rate changes and will have a lower duration.
[3 – 4 marks]
Duration can be used to assess the change in the value of a bond when interest rates change
using the following formula:
ΔP = [-D x Δi x P] / [1 + i], where P is the price of the bond, D is the duration and i is the
redemption yield.
However, duration is only useful in assessing small changes in interest rates because of
convexity. As interest rates increase the price of a bond decreases and vice versa, but this
decrease is not proportional for coupon paying bonds, the relationship is non-linear. In fact
the relationship between the changes in bond value to changes in interest rates is in the shape
of a convex curve to origin, see below.
A3-2
[2 – 3 marks]
Duration, on the other hand, assumes that the relationship between changes in interest rates
and the resultant bond is linear. Therefore duration will predict a lower price than the actual
price and for large changes in interest rates this difference can be significant.
Duration can only be applied to measure the approximate change in a bond price due to
interest changes, only if changes in interest rates do not lead to a change in the shape of the
yield curve. This is because it is an average measure based on the gross redemption yield
(yield to maturity). However, if the shape of the yield curve changes, duration can no longer
be used to assess the change in bond value due to interest rate changes.
[2 – 3 marks]
(c)
Industry risk
Industry risk refers to the strength of the industry within the country and how resilient it is
to changes in the country’s economy. Industry risk could be assessed using such factors as
the impact of economic forces on industry performance, the cyclical nature of the industry
(and the extent of the peaks and troughs) and the extent to which industry demand is affected
by economic forces.
Earnings protection
Earnings protection refers to how well the industry will be able to protect its earnings in
the wake of changes in the economy. This could be assessed using such factors as diversity
of the customer base, sources of future earnings growth and profit margins and return on
capital.
Financial flexibility
Financial flexibility refers to the ease with which companies can raise finance in order to
pursue profitable investment opportunities. This could be assessed by evaluating future
financial needs, the range of alternative sources of finance available, the company’s
relationship with its bank and any debt covenants that may restrict operations.
A3-3
Evaluation of the company’s management
This refers to how well management is managing the company and planning for its
future. This could be assessed by looking at the company’s planning, controls, financing
policies and strategies; merger and acquisition performance and record of achievement in
financial results; the overall quality of management and succession planning.
[2 marks for each criteria]
Answer 2
(a)
Years
Current government bond yield
Add: Yield spreads (A rating)
1
3.20%
0.65%
2
3.70%
0.76%
3
4.20%
0.87%
4
4.80%
1.00%
5
5.00%
1.12%
3.85%
4.46%
5.07%
5.80%
6.12%
[1]
Expected bond value at A rating – to be redeemed in 3 years’ time
Bond value (A rating) =
4
4
104


 97.178
2
1.0385 1.0446 1.0507 3
Expected percentage fall in the market value =
[1]
98.71  97.178
100%  1.55%
98.71
[1]
(b)
Financial implications of each of the two options
(i) Value of 5% bond
Spot rates applicable to Levante Co are those calculated above:
Years
Current government bond yield
Add: Yield spreads (A rating)
1
3.20%
0.65%
2
3.70%
0.76%
3
4.20%
0.87%
4
4.80%
1.00%
5
5.00%
1.12%
3.85%
4.46%
5.07%
5.80%
6.12%
Value of 5% fixed coupon bond:
=
5
5
5
5
105




 95.72
2
3
4
1.0385 1.0446 1.0507 1.0580 1.0612 5
[1]
A3-4
Hence the bond will need to be issued at a discount if only a 5% coupon is offered.
(ii) New coupon rate for bond valued at $100 by the market
Take R as the coupon rate, such that:
R
R
R
R
R
100





 100
2
3
4
5
1.0385 1.0446 1.0507 1.0580 1.0612 1.0612 5
4.2826R + 74.30 = 100
R = 6%
[4]
Advise to directors
If only a 5% coupon is offered, the bonds will have to be issued at just under a 4·3% discount.
To raise the full $150 million, if the bonds are issued at a 4·3% discount, then 1,567,398 $100
bond units need to be issued, as opposed to 1,500,000. This is an extra 67,398 bond units for
which Levante Co will need to pay an extra $6,739,800 when the bonds are redeemed in five
years.
On the other hand, paying a higher coupon every year of 6% instead of 5% will mean that an
extra interest of $1,500,000 ($9m – $7.5m) is needed for each of the next five years.
If the directors feel that the drain in resources of $1,500,000 every year is substantial and that
the project’s profits will cover the extra $6,739,800 in five years’ time, then they should issue
the bond at a discount and at a lower coupon rate. On the other hand, if the directors feel that
they would like to spread the amount payable then they should opt for the higher coupon
alternative.
[2 – 3 marks]
(c)
Industry risk
Industry risk refers to the strength of the industry within the country and how resilient it is
to changes in the country’s economy. Industry risk could be assessed using such factors as
the impact of economic forces on industry performance, the cyclical nature of the industry
(and the extent of the peaks and troughs) and the extent to which industry demand is affected
by economic forces.
Earnings protection
Earnings protection refers to how well the industry will be able to protect its earnings in
A3-5
the wake of changes in the economy. This could be assessed using such factors as diversity
of the customer base, sources of future earnings growth and profit margins and return on
capital.
Financial flexibility
Financial flexibility refers to the ease with which companies can raise finance in order to
pursue profitable investment opportunities. This could be assessed by evaluating future
financial needs, the range of alternative sources of finance available, the company’s
relationship with its bank and any debt covenants that may restrict operations.
Evaluation of the company’s management
This refers to how well management is managing the company and planning for its
future. This could be assessed by looking at the company’s planning, controls, financing
policies and strategies; merger and acquisition performance and record of achievement in
financial results; the overall quality of management and succession planning.
(d)
Here:
F = 1,050
π = (25 × 12)/1,050 = 0.286
S=0
L = 400/1,050 = 0.381
Interest = (250 × 0.04) + (150 × 0.05) = 17.5
C = 450/17.5 = 25.7
σ = 0.08
[3]
Y = 4.41 + (0.0014 × 1,050) + (6.4 × 0.286) – 0 – (2.72 × 0.381) + (0.006 × 25.7) – (0.53 ×
0.08)
Y = 4.41 + 1.47 + 1.830 – 1.036 + 0.154 – 0.042 = 6.79
The Kaplan-Urwitz model predicts that the credit rating will be AAA.
A3-6
[2]
[1]