Question
We have a group case study to do, we have answered most of the questions that require calculations and only the written work is left. I was assigned with two questions to answer which should at least take 2 pages. I will include the case, the work my group mates have written as well as the excel answers.
The written questions are on the second page of the case study, and I am assignmed with the 3rd and 6th questions. (3rd: • Should one use the nominal or the effective YTM when comparing the return on bonds with that of other securities?) (6th: • How likely it is that KLX will call bond II?)
The grading will be based on “All case reports will be graded on content (i.e., analytical reasoning and application of finance principles) and writing (i.e., the ability to clearly and effectively justify”
Answer
Case Study Questions
Question 1
Should one use the nominal or the effective YTM when comparing the return on bonds with that of other securities?
When a person invests in bonds, the most effective way of doing an analysis of the returns from the date of purchase up to the bond maturity date is through doing a comparison between the nominal and the effective yield. One can only pay the original price on the certificate only when they buy a bond on its issue date. The coupons on the bond outline the interest rate to be paid and that has an effect on the price paid by the investor. The market interest rates are subject to fluctuation hence have an effect on the price that one purchase or sells a bond. The prices can be higher or lower compared to the prevailing market interest rates. The bond issuer pays the par value or the face value at the maturity date of the bond. One will buy the bond at a discount or pay a premium unless the bond was purchased at its issue date. The par value is used for calculating the nominal yield to maturity. The bond prices fluctuate based on their effective yield, and not nominal, on many occasions. When the bond matures, one receives the full par value or face value in addition to a final interest payment.
Therefore, one should use the effective yield to maturity when comparing the return on bonds with that of other securities since the prices of the bonds are based on the effective yield. The payment rates may also differ thus making the effective yield better in comparing bonds with other securities. Yield is affected by the price one pays for the bonds, and the effect is on both the nominal and effective yield.
Question 2
How likely it is that KLX will call bond II?
A bond is callable or redeemable when the issuer has the privilege of calling the bond before it attains its maturity date. It thus implies that the issuer can buy back the bonds at a call price that has been defined. The call price will be higher than the face value. Bonds are in most cases called back when there is a decline in the interest rates. The bonds are called back for the purposes of refinancing a debt at a lower interest rate. A person or a company calls the current bonds and then issues them back at interest rate that is lower than the previous one. The value of a bond depends on the date that it is called back before the maturity period. When it is called back much earlier than the maturity date, the call value will be much higher compared to when it is called back when it is close to the maturity date.
The likelihood that KLX will call bond II is high because with an interest rate of 7.5 percent compared to the other three bonds, the refinancing of the debt can be done at a lower interest rate compared to the other bond I and Bond III that have an interest rate of 8.073 and 7.99 percent respectively. Bond II can be considered as relatively expensive compared to the rates that exist in the market due to the relatively lower interest rate when it attains its maturity compared to the other two bonds.
