CHAPTER 6 CASE Evaluating Annie Hegg’s Proposed Investment
in Atilier Industries Bonds
A
nnie 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% coupon interest
rate, are convertible into 50 shares of common stock, and can be called any time
at $1,080. 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 agen-
cies are considering a rating change for Atilier bonds. Recent economic data
suggest that inflation, currently at 5% annually, is likely to increase to a 6%
annual rate.
Annie remains interested in the Atilier bond but is concerned about infla-
tion, a potential rating change, and maturity risk. In order to get a feel for the
potential impact of these factors on the bond value, she decided to apply the val-
uation techniques she learned in her finance course.Required
a. If price of the the common stock into which the bond is convertible rises to
$30 per share after 5 years and the issuer calls the bonds at $1,080, should
Annie let the bond be called away from her or should she convert it into com-
mon stock?
b. For each of the following required returns, calculate the bond’s value, assum-
ing annual interest. Indicate whether the bond will sell at a discount, at a pre-
mium, or at par value.
(1) Required return is 6%.
(2) Required return is 8%.
(3) Required return is 10%.
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. Com-
pare and discuss differences between the bond values for each required return
calculated here and in part bunder the annual versus semiannual payment
assumptions.
d. If Annie strongly believes that inflation will rise by 1% during the next 6
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% 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%, 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%. Compare your finding to that in part f,and
comment on the bond’s maturity risk.304 PART 2 Important Financial Concepts