Question

Evaluating Annie Hegg's Proposed Investment in Atilier Industries Bonds

Annie Hegg has been considering investing in the bonds of Atilier Industries. The bonds were issued 5 years ago at their $ 1,000 par value and have exactly 25 years remaining until they mature. They have an 8.0 % coupon interest rate, are convertible into 50 shares of common stock, and can be called any time at $ 1,080.00. The bond is rated Aa by Moody's. 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, Moody's and other rating agencies are considering a rating change for Atilier bonds. Recent economic data suggest that expected inflation, currently at 5.0 % annually, is likely to increase to a 6.0 % annual rate.

Annie remains interested in the Atilier bond but is concerned about inflation, a potential rating change, and maturity risk. 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 finance course.

To Do

a. If the price of the common stock into which the bond is convertible rises to $ 30.00 per share after 5 years and the issuer calls the bonds at $ 1,080.00, should Annie let the bond be called away from her or should she convert it into common stock?

b. For each of the following required returns, calculate the bond's value, assuming annual interest. Indicate whether the bond will sell at a discount, at a premium, or at par value.

(1) Required return is 6.0 %.

(2) Required return is 8.0 %.

(3) Required return is 10.0 %.

c. Repeat the calculations 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 assumptions.

d. If Annie strongly believes that expected inflation will rise by 1.0 % during the next few months, what is the most she should pay for the bond, assuming annual interest?

e. If the Atilier bonds are downrated by Moody's from Aa to A, and if such a rating change will result in an increase in the required return from 8.0 % to 8.75 %, what impact will this have on the bond value, assuming annual interest?

f. If Annie buys the bond today at its $ 1,000 par value and holds it for exactly 3 years, at which time the required return is 7.0 %, how much of a gain or loss will she experience in the value of the bond (ignoring interest already received and assuming annual interest)?

g. Rework part (f), assuming that Annie holds the bond for 10 years and sells it when the required return is 7.0 %. Compare your finding to that in part (f), and comment on the bond's maturity risk.

h. Assume that Annie buys the bond at its current price of $ 983.80 and holds it until maturity. What will her current yield and yield to maturity (YTM) be, assuming annual interest?

i. After evaluating all of the issues raised above, what recommendation would you give Annie with regard to her proposed investment in the Atilier Industries bonds?

Step 1

Since you have posted a question with multiple sub-parts, we will solve first three sub-parts for you. To get remaining sub-part solved please repost the complete question and mention the sub-parts to be solved.

Step 2

Part a:

A callable bond is one in which an issuer may redeem the bond before the maturity period. If the issuer gets an option to borrow at better rates, then the issuer calls back its outstanding bonds (with embedded call option).

In case of a convertible bond, the investor will have the option to convert the bond into specific number of shares.

In the given question, the bond is convertible into 50 shares and the price per share is $30. When the bond is converted to shares, Annie will get an amount of $1500 (we get $1500 by multiplying the number of shares with the price per share). Annie can get $1080, if she does not convert.

As $1500 is greater than $1080, Annie should choose to convert the bond.

Step 3

**Part b:****(1):**

The present value of the bond is $1,255.67 which is more than the face value of $1000...

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