Abstract of the analysis The Case is..

The case is concerned about Annie Heggs proposed investment in Atilier Industries Bonds. We solved the case with our best effort. We tried to make it sure that the investment that Annie Hegg is going to make is safe and will ensure maximum level of return for the investor. We explore the best consulting agencies portfolio to know the standard of analysis. We keep it in mind that our calculation will help someone to take a decision that would cause optimum return or optimum loss to that person. So, very precisely, we attempted to suggest the best and safest rates to the specific issues of the case. Moreover, we were aware of the optimum return that the investor should get from the investment decisions.

In the analysis, we tried to project some specific suggestions that would be helpful to the investor to invest in the concerned bond. Moreover, we let the investor know what should be his/her required rate of return though we have not been provided sufficient data regarding the market. Our analysis is specially based on the nature of the instrument, for which, the investor is going to invest handsome amount money.

Different required calculations are shown in the analysis to make it more authentic and reliable. The analysis will be successful if it can serve the purpose of the investors i.e. not only to secure the optimum return but also to understand the reasons behind the decisions and their proper implementation in practical field.

Annie Hegg has been considering investing in the bonds of Atilier Industries. The bonds were issued 5 years ago at their $1000 per value and have exactly 25 years remaining until they mature. They have an 8% coupon interest rate, are convertible into 50 shares of common stock, and can be called any time at $1080.the bond is rated Aa by Moodys. Atilier Industries, a manufacturer of sporting goods, recently acquired a small athletic-wear company that was in financial distress. As a result of the acquisition, Moodys and other rating agencies are considering a rating change for Atilier bonds. Recent economic data suggest that the inflation, currently at 5% annually, is likely to increase to a 6% annual rate. Annie remains interested in the Atilier bond is concerned about inflation, a potential rating change, and maturity risk. In order to get a feel for the potential impact of these factors on the bond value, she decided to apply the valuation techniques she learned in her financial course. Required a. If price of the common stock into which the bond is convertible rises to $30 per share after 5 years and the issuer calls the bonds at $1080, should Annie let the bond be called away from her should she convert it into common stock? b. For each of the following required returns, calculate the bonds value, assuming annual interest. Indicate whether the bond will sell at a discount, at a premium or at par value. 1) Required return is 6% 2) Required return is 8% 3) Required return is 10% c. Repeat the calculation in part b, assuming that interest is paid semiannually and that the semiannual required returns are one-half of those shown. Compare and discuss differences between the bond values for each required return calculated here and in part b under the annual versus semiannual payment assumption. d. If Annie strongly believes that inflation will rise by 1% during the next 6 months, what is the most she should pay for the bond, assuming annual interest? e. If the Atilier bonds are down rated by Moodys from Aa to A, and if such a rating change will result in an increase in the required return from 8% to 8.75%, what impact will this have on the bond value, assuming annual interest? f. If Annie buys the bond today at its $1000 per value and holds it for exactly 3 years, at which time the required return is 7%, how much of a gain or loss will she experience in the value of the bond (ignoring interest already received and semiannual interest)? g. Rework part f, assuming that Annie holds the bond for 10 years and sells it when the required return is 7%. Compare your finding to that in part f, and comment on the bonds maturity risk. h. Assume that Annie buys the bond at its current closing price of 98.38 and holds it until maturity. What will her yield to maturity (YTM) be assuming annual interest? i. After evaluating all of the issues rose above, what recommendation would you give Annie with regard to her proposed investment in the Atilier Industries bonds?

Client Profile
Name: Annie Hegg Profession: Student

Case to be resolved
(Major: Finance)

Investment instrument: Bond Nature of the investment instrument: Debt secured or unsecured First came in the market: 5 years ago Remaining life time: 25 years Coupon interest rate: 8% Call-on price: $ 1080 Conversion rate: 50 shares per bond Rating of the bond: Aa by Moodys. Merger with: A small athletic-wear company Special information: The rating of the company Is going to be changed since Moody & other rating agencies have already started working. Existing Inflation rate: 5% Possible change in the inflation rate: +1% Related risk identified: 1. Inflation 2. A potential rating change 3. maturity risk Special feature: Call-on option, convertible Investing concern: Atilier Industries bond

Calculation required for the case

A.
After 5 years,

Call price =$1080 We know, Call price = Face value+ interest (Extra payment to the bond holder) Interest Income = Call Price-Face Value

= $ 1080 - $ 1000 = $ 80

Stock price = $ (30 50) = $1500 If she sells the stock at the end of the 5th year, then she will get Income from sale of Stock= $ (1500-1000) = $500

ANALYSIS

At the end of 5th year, Stock Price > Call Price

DECISION

Bonds should be converted into common stock

B.

1. When RRR = 6%, BO = I PVIFA 6%, 25yrs + M PVIF 6%, 25yrs = $ 80 12.783 + $ 1000 0.233 = $ 1255.64
1500
1255.64

Bond Value ($)

1000 818.16

2. When RRR = 8%, BO = I PVIFA 8%, 25yrs + M PVIF 8%, 25yrs = $ 80 10.675 + $ 1000 0.146 = $ 1000 3. When RRR = 10%, BO = I PVIFA 10%, 25yrs + M PVIF 10%, 25yrs = $ 80 9.077 + 1000 0.092 = $ 818.16

1000 500 0 6%

8%

10%

Graph 1: Bond value at different RRR

Table 1: Analysis and Decision

Coupon Interest Rate (CIR)

Required Rate of Return (RRR)

BO

Par Value

Analysis

Decision

8% 8% 8%

6% 8% 10%

$ 1255.64 $ 1000 818.16

$1000 $1000 $1000

RRR< CIR RRR= CIR RRR> CIR

Premium At Par Discount

C.
2. BO 3. BO

1. BO

= [I2] PVIFA 6%/2, 252yrs + M PVIF 6%/2, 252 yrs = [802] 25.730 +1000 0.228 =$ 1257.20

= [I2] PVIFA 8%/2, 252yrs + M PVIF 8%/2, 252 yrs = 40 21.482 + 1000 0.141 = $ 1000.28

= [I2] PVIFA 10%/2, 252yrs + M PVIF 10%/2, 252 yrs = 40 18.256 + 1000 0.087 = $ 817.24

Annually

RRR

Semiannually

Table 2: Annual versus Semiannual payments

$ 1255.64 $ 1000 818.16

6% 8% 10%

$ 1257.20 $ 1000.28 $ 817.24

$1,255.64 $1,257 1000 1000.28

$1,400.00 $1,200.00 $1,000.00 $800.00 $600.00 $400.00

818.16 817.24 Annua l Semiannual

Graph 2: Annual versus Semiannual payments

$200.00 $0.00 6% 8% 10%

D.
Here, =3%

To solve the problem, we must consider the fisher effect on the RRR since correlation between RRR & inflation has not been given.

The coupon interest rate is 8%, So the real rate= (8-5) % The Fisher Effect defines the relationship between real rates, nominal rates and inflation (1 + R) = (1 + r) (1 + h), where R = nominal rate r = real rate
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Therefore, the inflation adjusted rate of return should be: R = (1+0.03) (1+0.06)-1 =9.18% BO = I *(1+) - 1 (1+) + + M *1 (1+) + = $80 [(1+.0918) -1.0918 (1+.0918) ] + $ 1000*1 (1+.0918) ] = 718.8979 97.8891 + 111.2814 = $ 732.2902
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h = expected inflation rate

Moreover, it is a common tradition that investors calculate their

E.
value ($1000).

For 8%, BO = $ I PVIFA 8%, 25yrs+ M PVIF 8%, 25yrs = $ 80 10.675 + $ 1000 0.146 = $ 1000 For 8.75%, BO = I *(1+) - 1 (1+) + + M *1 (1+) ] = $80 [(1+.0875)25-1.0875 (1+.0875)25+ + $ 1000*1 (1+.0875)25] = $ 921.2068

Here the RRR (8.75%) is greater than CIR (8%), so the BO ($ 921.2068) is less than its par

Down rated from Aa to A

Less Liquidity

Higher Need of Working Capital

Higher Default Risk

Greater Obligation

Higher Cost of Debt

Higher Premium

Higher RRR

Higher Cost of Capital

Figure 2: Effect of down rated from Aa to A

F.
G.
Maturity Period:

When, n = (25 3) yrs = 22yrs BO = I PVIFA 7%, 22yrs + M PVIF 7%, 22yrs = $ 80 11.061 + $ 1000 0.226 = $ 1110.88

M = $ 1000 Gain = BO M = $1110.88 $ 1000 = $ 110.88

When, n = (25 10) yrs = 15yrs BO = I PVIFA 7%, 15yrs + M PVIF 7%, 15yrs = $ 80 9.108 + $ 1000 0.362 = $ 1090.64 M = $ 1000 Gain = BO M = $ 1090.64 - $ 1000 = $ 90.64

F
3 Lower <

G
10 Higher

Maturity Risk:

Reason: The longer the maturity, the more the value of a security will change in response to a given change in interest rates.

H.
Trial & Error: Trying 9%, we get = $ 901.84 Next we try for 7%,

Here 983.8 = I PVIFA kd, 25yrs + M PVIF kd, 25yrs We need to solve the equation for kd, the YTM.

Because we know that a required return, kd, of 8% would result in a value of $ 1000, the premium rate that would result in $ 983.8 may be greater or less than 8%.

I PVIFA 9%, 25yrs + M PVIF 9%, 25yrs = $ 80 9.823 + $ 1000 0.116

I PVIFA 7%, 25yrs + M PVIF 7%, 25yrs = $ 80 11.654 + $ 1000 0.184 = 1116.32 Now LR + [(PVLR Market Value)/ (PVLR PVHR)] (HR LR) = 0.07 + 132.52/ 214.48 0.02 = 0.0824 = 8.24%

Direct Formula: YTM = (I + Discount/ n) /Average Price = [(80 + (1000 983.8)/25)]/ [(1000+ 983.8)/ 2] = 8.13 %

Decision: Annie Hegg should consider 8.24% as YTM from the bond. But if the bond are of unsecured in nature then she should consider 8.13% as YTM.

I.
We recommend Annie Hegg to invest if and only if: 1. The situation mentioned here remains unchanged. 2. Required rate of return Is satisfactory to the investor. When a required return on a bond differs from the bonds coupon interest rate, the bonds value will differ from its par value. The required return is likely to differ from the coupon interest rate because either: Economic conditions changes. The firms risk changes. So, Annie should take care of both these factors. 3. Inflation adjusted required rate of return is sufficient to fulfill the demand of the investor. 4. Bond should b converted into stock when market price of the stock is such that conversion will provide a profit to the bond holder. 5. When Annie will decide to sell the bond she must forecast her gain and loss. Here premium and discount r important factors. She should analyze that whether the sale is in premium or in discount. IF, Bonds value > Market value then the sale is in premium Bonds value < Market value then the sale is in discount. 6.The credit quality of most issuers and their obligations is not fixed and steady over a period of time, but tends to undergo change. For this reason changes in ratings occur so as to reflect variations in the intrinsic relative position of issuers and their obligations.

A change in rating may thus occur at any time in the case of an individual issue. Such rating change should serve notice that Moody's observes some alteration in creditworthiness, or that the previous rating did not fully reflect the quality of the bond as now seen. While because of their very nature, changes are to be expected more frequently among bonds of lower ratings than among bonds of higher ratings. Nevertheless, the user of bond ratings should keep close and constant check on all

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ratings both high and low to be able to note promptly any signs of change in status that may occur. So, Annie must make herself sure about the bond rating factor as it exerts much impact incase of investment in bonds. We may help her by providing the following bond rating chart: Moodys and Standard & Poors Bond Ratings:

Moodys Aaa Aa A Baa Ba B Caa Ca C

Interpretation Prime equality High grade Upper medium grade Medium grade Lower medium grade Speculative From very speculative To near or in default Lowest grade

Standard & Poors AAA AA A BBB BB B CCC CC C D

Interpretation Bank investment quality

Speculative

Income bond In default

7.If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return. So, she should also analyze the default risk as well. 8.She should be concern about interest rate risk, whether it is rising or not because a rise in interest rates, and therefore in the required return , cause a decrease in bonds value. In fine, we should say that, our calculation in the different sections of this analysis depicts the true picture of the total investment scenario in the concerned issue. Therefore, investors can easily change the decision complying with the changed situation just having a glimpse on the analysis we have forwarded.

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