question archive Agland Ltd issues a 20-year coupon-bearing bond at par with a sinking fund provision requiring that 5 percent of the issue be retired each year
Agland Ltd issues a 20-year coupon-bearing bond at par with a sinking fund provision requiring that 5 percent of the issue be retired each year
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Agland Ltd issues a 20-year coupon-bearing bond at par with a sinking fund provision requiring that 5 percent of the issue be retired each year. The par value of the bond is $1000.
Foglund Ltd issues a 20-year coupon-bearing bond which is callable with call protection over only the first five years. The bond is issued at par, where the par value is $1000; and its coupon rate is
8 percent.
Foglund Ltd and Bigbury Ltd are in the same industry and in the same country; and they have both issued their 20-year coupon-bearing bonds on the same day at par. However, the Bigbury bond is not callable while the Foglund bond is callable, as stated above.
The three firms share a uniform level of business risk.
Required:
You are not required to compute exact numerical solutions. Your task is to describe, in sentences, the relevant ideas and characteristics.
(i) Assuming Agland Ltd’s bond trust deed allowed the company to call the 5 percent of bonds to be retired in any particular year, explain under what market conditions it would choose to make a call (as distinct from using the other method for retiring the bonds).
(ii) Agland Ltd does not necessarily have to make a call in order to retire the five percent of the bond issue each year. What is the alternative method Agland Ltd can employ, and under what market circumstances would it use this alternative method?
(iii) If we expect Foglund Ltd to make a call at the start of the sixth year, what interest rate would we compute to assess the attractiveness of this bond as an investment, and what information about the Foglund bond would we require to compute the value of this variable?
(iv) Explain the points of similarity and difference between the Bigbury Ltd and Foglund Ltd bond issues that we would expect to be evident in their YTMs and coupon rates of interest. Explain why these similarities and differences exist.
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Answer :-
1. When the market interest rate goes below its current market interest rate
2. Redeem the bond at maturity
3. The market interest rate at the start of the sixth year and the market price of the Bigbury bond
4. Foglund has the option to call while Bigbury does not.
Explanation:
(1)
Callable bonds give the issuer option to redeem the bond before its maturity and the issuer redeems a bond early when the market interest rate decreases. So, if the market interest rate goes below its current market interest rate in any particular year, Agland Ltd might choose to make a call in that year.
(2)
Callable bonds have two options, either to redeem the bond in a particular year as per terms of the bond before maturity or to carry the bond until maturity. If Agland Ltd. does not want to make the call, then it can redeem the bond at maturity. The company would choose this option when the market interest rate increases or it does not change.
(3)
If Foglund Ltd. is making a call at the start of the sixth year, they would calculate the interest rates they would have to pay if they issued a new bond at the start of the sixth year which will be evaluated by the market interest rate and to calculate market interest rate, Foglund Ltd would take the current market price of the Bigbury Ltd.'s bond to calculate the same.
(4)
There are a lot of similarities between Bigbury Ltd and Foglund Ltd bond issues like they have the same coupon rate, same issue price, same maturity date, and same coupon payments. Now, there is some difference between these bonds as well which are Bigbury's bond is non-callable while Foglund's bond is callable within first 5 years which means Foglund has an option to redeem its bond anytime in the first five years if they get a better opportunity to raise the funds at a lesser rate of interest while Bigbury does not share this option and has to carry the bond till its maturity.
