FIN 402 Week 4 Textbook Case Problems

Textbook Case Problems Week 4

FIN/402

Textbook Case Problems

10.1

Describe the type of bond investment program you think the Shuman family should follow. In answering this question, give appropriate consideration to both return and risk factors.

I think it would be best for the Shuman family to follow a long-term investment program. It would be best for the portfolio to be highly diversified with high returns of capital appreciation, without having to sacrifice liquidity.

List several types of bonds that you would recommend for their portfolio and briefly indicate why you would recommend each.

Municipal bonds, Treasury bonds, and Agency bonds would be good choices for their objective. Municipal bonds are issued by state government, local authorities, and political subdivisions. Treasury bonds have a maturity of 2-3 years and are backed by the US government. They are also very liquid. Agency bonds are similar to Treasury bonds, but they are issued by agencies and organization of the US government. The biggest difference between a Treasury bond and an Agency bond is that the US treasury does not accept the obligation of Agency bonds.

Using a recent issue of the Wall Street Journal, Barron’s, or an online source, construct a $200,000 bond portfolio for the Shuman family. Use real securities and select any bonds (or notes) you like, given the following ground rules:

The portfolio must include at least one Treasury, one agency, and one corporate bond; also, in total, the portfolio must hold at least five but no more than eight bonds or notes.

No more than 5% of the portfolio can be in short-term U.S. Treasury bills (but note that if you hold a T-bill, that limits your selections to just seven other notes/bonds).

Ignore all transaction costs (i.e., invest the full $200,000) and assume all securities have par values of $1,000 (although they can be trading in the market at something other than par).

Use the latest available quotes to determine how many bonds/notes/bills you can buy.

Security investments:

10% Treasury bonds – $13,800

Agency bonds – $25,100

Corporate bonds – $11,500

Municipal bonds – $37,200

Zero coupon bonds – $112,400

Prepare a schedule listing all the securities in your recommended portfolio. Use a form like the one shown below and include the information it calls for on each security in the portfolio.

In one brief paragraph, note the key investment attributes of your recommended portfolio and the investment objectives you hope to achieve with it.

For this portfolio, the main objective is capital appreciation, which is a stated goal of all mutual funds and diversified portfolio. Capital appreciation is a rise in the asset value, based on the market price. With this portfolio, the goal is to gradually increase the funds invested over a long period of time.

10.2

Three of these companies have bonds that carry investment-grade ratings. The other three companies carry junk-bond ratings. Judging by the information in the table, which three companies have the investment-grade bonds and which three have the junk bonds? Briefly explain your selections.

The three companies that carry investment grade ratings are companies 2, 3, and 6. These companies have higher current ratios, higher net profit margin, and a lower long term debt to total capital.

The companies that carry junk bond ratings are 1, 4, and 5. These companies have lower current ratios, lower net profit margin, and higher long term debt to capital ratio.

One of these six companies is an AAA-rated firm and one is B-rated. Identify those companies. Briefly explain your selections.

Company 3 is AAA rated, while company 4 and 5 are B rated firm. Company 3 has the highest pretax interest coverage, indicating it has a higher credibility. Company 4 carries junk bond ratings due to the highest long term debt to total capital among the 6 companies. It also has the lowest liquidity, efficiency and profitability.

Of the remaining four companies, one carries an AA rating, one carries an A rating, and two have BB ratings. Which companies are they?

Company 6 has the AA rating, while company 2 has the A rating. Company 1 and company 5 have the BB ratings.

11.1

Regarding the short-term trading opportunity:

What basic trading principle is involved in this situation?

Trading on forecasted interest rate behavior

If Marlene’s expectations are correct, what will the price of this bond be in two years?

852 * .09 = 76.68

76.68 / .08 = 958.50

What is the expected return on this investment?

8.365

Should this investment be made? Why?

I believe the investment should be made because there are good returns and interest rates. She believes the bond price will go up and the NPV continues to remain stable at just over 7.5%. If everything goes the way it is forecasted to go, this would definitely be a good investment option.

Regarding the bond swap opportunity:

Compute the current yield and the promised yield (use semiannual compounding) for the bond the Carters currently hold and for each of the three swap candidates.

Current Yield:

70 / 785 = .08975 / 780 = .096

65 / 885 = .07380 / 950 = .084

BP = 785 = 70/(1+.089)*1+70/(1+.089)*2+70/(1+.089)*3+70/(1+.089)*4+70/(1+.089)*5+70/(1+.089)*6+70/(1+.089)*7+70/(1+.089)*8+70/(1+.089)*9+70/(1+.089)*10+70/(1+.089)*11+70/(1+.089)*12+70/(1+.089)*13+70/(1+.089)*14+70/(1+.089)*15+70/(1+.089)*16+70/(1+.089)*17+70/(1+.089)*18+70/(1+.089)*19+70/(1+.089)*20+70/(1+.089)*21+70/(1+.089)*22+70/(1+.089)*23+1000/(1+.089)*23 = 816.5584-56

BP = 780 = 75/(1+.096)*1+75/(1+.096)*2+75/(1+.096)*3+75/(1+.096)*4+75/(1+.096)*5+75/(1+.096)*6+75/(1+.096)*7+75/(1+.096)*8+75/(1+.096)*9+75/(1+.096)*10+75/(1+.096)*11+75/(1+.096)*12+75/(1+.096)*13+75/(1+.096)*14+75/(1+.096)*15+75/(1+.096)*16+75/(1+.096)*17+75/(1+.096)*18+75/(1+.096)*19+75/(1+.096)*20+75/(1+.096)*21+75/(1+.096)*22+75/(1+.096)*23+1000/(1+.096)*23 = 807.8147245

BP = 885 = 65/(1+.073)*1+65/(1+.073)*2+65/(1+.073)*3+65/(1+.073)*4+65/(1+.073)*5+65/(1+.073)*6+65/(1+.073)*7+65/(1+.073)*8+65/(1+.073)*9+65/(1+.073)*10+65/(1+.073)*11+65/(1+.073)*12+65/(1+.073)*13+65/(1+.073)*14+65/(1+.073)*15+65/(1+.073)*16+65/(1+.073)*17+65/(1+.073)*18+65/(1+.073)*19+65/(1+.073)*20+65/(1+.073)*21+65/(1+.073)*22+65/(1+.073)*23+1000/(1+.073)*23 = 912.0866784

BP = 950 = 80/(1+.084)*1+80/(1+.084)*2+80/(1+.084)*3+80/(1+.084)*4+80/(1+.084)*5+80/(1+.084)*6+80/(1+.084)*7+80/(1+.084)*8+80/(1+.084)*9+80/(1+.084)*10+80/(1+.084)*11+80/(1+.084)*12+80/(1+.084)*13+80/(1+.084)*14+80/(1+.084)*15+80/(1+.084)*16+80/(1+.084)*17+80/(1+.084)*18+80/(1+.084)*19+80/(1+.084)*20+80/(1+.084)*21+80/(1+.084)*22+80/(1+.084)*23+1000/(1+.084)*23 = 959.8301109

Do any of the swap candidates provide better current income and/or current yield than the Beta Corporation bonds the Carters now hold? If so, which one(s)?

Two of the swap candidates provide better current income and current yield than the Beta Corporation bonds currently held. Root Canal Products of America has a better yield than the Beta Corporation bonds held. Root Canal Products offers a promised yield of 912, and the Beta Corporation offers a promised yield of 817. Kansas City Dental insurance offers a higher yield than the current bond, as well. They offer a promised yield of 960, which is also higher than the current bond held.

Do you see any reason why Marlene should switch from her present bond holding into one of the other issues? If so, which swap candidate would be the best choice? Why?

I think it would be beneficial for Marlene to switch from her present bond holding to one of the other two issuers. These other options offer higher yields with current income opportunities. I would suggest Kansas City Dental Insurance because they offer the highest promised yield and the current yield is just below that of the current bond.

11.2

Given the information provided, find the current yield and the promised yield for each bond in the portfolio. (Use annual compounding.)

Current yield = > annual interest income / current market price of bond

12 YR bond = 75 / 895 = 8.38%

YTM

895 = > 75 * PVIFA 1%, 12 period + 1,000 * PVIF 1%, 12 period = > 8.96%

10 YR Zero bond = > 0 / 405 = > 0%

YTM

405 = 1000 + PVIF 405 = > 9.45%

10 YR bond = > 10 / 1080 = > 9.26%

YTM

1080 = 100 * PVIFA 1%, 10 period + 1,000 * PVIF 1%, 10 period = > 8.77%

15 YR bond = > 92.5 / 980 = > 9.44%

YTM

980 = 92.50 * PVIFA 1%, 15 period +1,000 * PVIF 1%, 15 period = > 9.5%

Calculate the Macaulay and modified durations of each bond in the portfolio and indicate how the price of each bond would change if interest rates were to rise by 75 basis points. How would the price change if interest rates were to fall by 75 basis points?

Find the duration of the current four-bond portfolio. Given the seven-year target that Grace has set, would you consider this an immunized portfolio? Explain.

The weighted average duration of this portfolio is 8.4 years. Grace’s investment horizon is 7 years, so the bond portfolio is not immunized because the weighted average portfolio is greater than the horizon of the investment.

How could you lengthen or shorten the duration of this portfolio? What’s the shortest portfolio duration you can achieve? What’s the longest?

The bond with the maximum duration is the zero bond. The shortest duration would be the 10% bond. A 10-year bond is 6.89 years. In order to stretch the portfolio’s duration, she would need to invest in greater duration bonds, as well as, reduce the duration through investing in smaller duration bonds. With investing $200,000 in a 10-year bond, Grace would be able to accomplish the smallest duration possible.

Using one or more of the four bonds described above, is it possible to come up with a $200,000 bond portfolio that will exhibit the duration characteristics Grace is looking for? Explain.

Grace is planning to cash out on the bond portfolio in roughly 7 years, so we must find a portfolio that has a weighted average duration of 7 years. The easiest way to immunize her portfolio so there is no interest rate risk is to invest all of the $200,000 in a 10 year, 10% bond, with a duration of about 6.89. To get a fully immunized portfolio with a 7-year duration exactly, we consider the 12 year, 7.5% bond with its 8.07-year duration, as well as, a 10 year, 10% bond with a 6.89-year duration.

Using one or more of the four bonds, put together a $200,000 immunized portfolio for Grace. Because this portfolio will now be immunized, will Grace be able to treat it as a buy-and-hold portfolio-one she can put away and forget about? Explain.

Grace should not treat it at a put away and forget about it portfolio, even with it being immunized. The portfolio will still need to be watched and continued to be balanced to reflect the changes in market interest rates.