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question from Kaplan Revision kit
Levente Co DEC 11 Adapted)
company is willling to raise borrowing with bond redeemable at par in five years time
given,
spot yield curve, with adjusted Credit spread
Year 1= 3.85%, year 2 = 4.46%, yr 3 = 5.07, yr 4 = 5.8,yr 5 = 6.12
The directors are considering the two following option,
1) issue the new bond at fixed coupon of 5% but at a premium or discount whichever is appropriate
2) issue the bond at a coupon rate where the issue price of new bond will be 100 per unit and equal to its par value.how to know which is appropriate in 1 & how to calculate coupon rate at 2
You will know from Paper F9 that the market value of a bond is the PV of the future interest and redemption receipts to the investor discounted at the relevant required return.
In the first case, we know the coupon rate and the redemption amount, so we discount each year at the relevant interest rate to get the market value (as the examiner has done in his answer – appreciate that, for example, multiplying by 1.0446^(-2) is another way of writing 1/(1.0446^2), which is discounting for 2 years at 4.446%.
In the second case we know the market value and the redemption amount. So again, the PV of the interest and repayment will equal the market value. So the examiner has let the coupon rate by R, set up the expression for the discounting, and then calculate what R is in order for the PV to equal the market value.
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