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Suppose a large firm seeks to raise capital by issuing a bond at the beginning of...

Suppose a large firm seeks to raise capital by issuing a bond at the beginning of 2017 with a $5,000 face value and $250 coupon payments to be made at the end of 2017, 2018, 2019, and 2020. The corporation will also repay the principle amount of the bond back to investors at the end of 2020\.

  1. What is the rate of interest that the firm is paying on its bonds?
  2. If Moody’s decides to upgrade the firm’s debt rating, what will be the likely result for the interest rate the firm will have to pay when it sells bonds? Briefly explain.
  3. If the discount rate is 2%, what is the present value of the bond?
  4. If the discount rate increases, then what will happen to the present value of the bond?
  5. If a new risk-free investment pays an interest rate of 5 percent what would happen to demand for the firm’s bonds?

I only need E answered, thank you

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Answer #1

E. If the new risk free rate pays an interest rate of 5%, then the demand for firm's bond will fall. As yield for firm's bond is also 5% but this investment is not risk free (as it have default risk and liquidity risk which risk free investment do not have), therefore investor will prefer risk free investment rather than firm's bond. This decline in demand for firm's bond will result in fall in the price of bond below 5,000 resulting in increasing yield of such bond.

This increase in firm's bond yield will then justify investor for investing in firm's bonds. Hence demand will reduce and price of bonds will also reduce.

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