Question

Finally, you hear that FL is contemplating offering a new 4-year bond to the public, but the structure of payments proposed is quite unusual. For the first two years the bond will not pay any coupons. Starting in the third year (30 months from now) the bond will pay equal semi-annual coupons for the remainder of its life. The annual coupon rate from year 3 through 4 is expected to be set at 10%.

5. Would you expect the yield on this bond to be above or below 4.4% and why?

6. Why would FL be considering issuing such a “step up” bond? FL will be selling each

   new bond at par value.

7. If the actual required return on this bond is 4.4%, would investors find it appealing?

   If FL is raising 100 million in this bond offering, how much value would FL be

   transferring to new investors?

8. What coupon rate should the company select if it wanted to ensure the price of the

bond (at par) would be fair (neither over or underpriced)?

Answer 1

I expect the yield on the bond to be above 4.4% based on the below caclculation.

Investment	100	4.4
Year	Interest receivable	Interest	Cumulative cashflow @ 4.4%
Year1		4.40	104.40
Year2		4.59	108.99
Year3	10	4.80	113.79
Year4	10	5.01	118.80
	20	18.80

b FL will be considering step up bond because it may want to avoid immediate cashflow.

c. IF FL is raising $100 million then it would have $120 million.

Investment in Million $	$                             100
Year	Interest receivable
Year1
Year2
Year3	$                               10
Year4	$                               10
Total	$                               20
Total investment	$                             120

The company should select 9.4% as coupon rate.

Investment	100	4.4
Year	Interest receivable	Interest	Cumulative cashflow @ 4.4%
Year1		4.40	104.40
Year2		4.59	108.99
Year3	9.4	4.80	113.79
Year4	9.4	5.01	118.80
	18.8	18.80