Grace has been considering investing in the bonds of SEM Berhad. The bonds were issued 5 years ago at their RM1,000 par 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 RM1,080. The bond is rated Aa by Moody’s. SEM Berhad, 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 SEM bonds. Recent economic data suggest that expected inflation, currently at 3% annually, is likely to increase to a 4% annual rate.
Grace remains interested in the SEM bond but is concerned about inflation, a potential rating change, and maturity risk. To get feel for the potential impact of these factors on the bond value, he decided to apply the valuation techniques he learned in his finance course.TO DO:
- If the price of the common stock into which the bond is convertible rises to RM30 per share after 5 years and the issuer calls the bonds at RM1,080, should Grace let the bond be called away from him or should he convert it into common stock?
- 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.
- a) Required return is 6%
- b) Required return is 8%
- c) Required return us 10%
- 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 assumptions.
- If Grace strongly believes that expected inflation will rise by 1% during the next few months, what is the most he should pay for the bond, assuming annual interest?
- If the SEM 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% to 8.76%, what impact will this have on the bond value, assuming annual interest?
- If Grace buys the bond today at its RM1,000 par value and holds it for exactly 3 years, at which time the required return is 7%, how much of a gain or loss will he experience in the value of the bond (ignoring interest already received and assuming annual interest)?
- Rework part (f), assuming that Grace 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 bond’s maturity risk.
- Assume that Grace buys the bond at its last price of 983.80 and holds it until maturity, what will his yield to maturity (YTM) be, assuming annual interest?
- After evaluating all of the issues raised above, what recommendation would you give Grace with regard to his proposed investment in the SEM Berhad bonds?