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Chapter 5: 3DQ (page 524)
What is the difference between a bond agreement and a bond indenture? (LO16-1)
A corporate bond agreement describes the basic terms linked with a bond; in comparison, a bond indenture covers each detail related to the issuance of the bond.
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Richmond Rent-A-Car is about to go public. The investment banking firm of Tinkers, Evers & Chance is attempting to price the issue. The car rental industry generally trades at a 20 percent discount below the P/E ratio on the Standard & Poor鈥檚 500 Stock Index. Assume that index currently has a P/E ratio of 25. The firm can be compared to the car rental industry as follows:
Richmond | Car Rental Industry | |
Growth rate in earnings per share..... | 15% | 10% |
Consistency of performance............. | Increased earnings 4 out of 5 years | Increased earnings 3 out of 5 years |
Debt to total assets..................... | 52% | 39% |
Turnover of product......................... | Slightly below average | Average |
Quality of management.................. | High | Average |
Assume, in assessing the initial P/E ratio, the investment banker will first determine the appropriate industry P/E based on the Standard & Poor鈥檚 500 Index. Then a half point will be added to the P/E ratio for each case in which Richmond Rent-A-Car is superior to the industry norm, and a half point will be deducted for an inferior comparison. On this basis, what should the initial P/E be for the firm?
Question: I. B. Michaels has a chance to participate in a new public offering by Hi-Tech Micro Computers. His broker informs him that demand for the 700,000 shares to be issued is very strong. His broker鈥檚 firm is assigned 25,000 shares in the distribution and will allow Michaels, a relatively good customer, 1.3 percent of its 25,000 share allocation. The initial offering price is \(30 per share. There is a strong aftermarket, and the stock goes to \)32 one week after issue. The first full month after issue, Mr. Michaels is pleased to observe his shares are selling for \(33.50. He is content to place his shares in a lockbox and eventually use their anticipated increased value to help send his son to college many years in the future. However, one year after the distribution, he looks up the shares in The Wall Street Journal and finds they are trading at \)28.50.
c. Why might a new public issue be expected to have a strong aftermarket?
Harold Reese must choose between two bonds: Bond X pays \(95 annual interest and has a market value of \)900. It has 10 years to maturity. Bond Zpays \(95 annual interest and has a market value of \)920. It has two years tomaturity.
a.Compute the current yield on both bonds.
b.Which bond should he select based on your answer to part a?
c.A drawback of current yield is that it does not consider the total life of thebond. For example, the yield to maturity on Bond X is 11.21 percent. Whatis the yield to maturity on Bond Z?
d.Has your answer changed between parts band cof this question?
A \(1,000 par value bond was issued 25 years ago at a 12 percent coupon rate. It currently has 15 years remaining to maturity. Interest rates on similar obligations are now 8 percent.
a. What is the current price of the bond? (Look up the answer in Table 16-2.)
b. Assume Ms. Bright bought the bond three years ago when it had a price of \)1,050. What is her dollar profit based on the bond鈥檚 current price?
c. Further assume Ms. Bright paid 30 percent of the purchase price in cash and borrowed the rest (known as buying on margin). She used the interest payments from the bond to cover the interest costs on the loan. How much of the purchase price of $1,050 did Ms. Bright pay in cash?
d. What is Ms. Bright鈥檚 percentage return on her cash investment? Divide the answer to part b by the answer to part c.
e. Explain why her return is so high.
An investor must choose between two bonds: Bond A pays \(72 annual interest and has a market value of \)925. It has 10 years to maturity. Bond B pays \(62annual interest and has a market value of \)910. It has two years to maturity.
Assume the par value of the bonds is $1,000.
a.Compute the current yield on both bonds.
b.Which bond should she select based on your answer to part a?
c.A drawback of current yield is that it does not consider the total life of thebond. For example, the yield to maturity on Bond A is 8.33 percent. What isthe yield to maturity on Bond B?
d.Has your answer changed between parts band cof this question in terms ofwhich bond to select?
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