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Bond Valuation Project

Dunn Company

Alex Garcia, Kelly Morse, Maddie Baird, Ashley Thomsen, Hannah Liggett,
Jessica Combs

December 7th, 2018


Executive Summary

The Dunn Company is considered a corporation because it has issued bonds for

Mutual of Maryville Company and a corporation is the only form of business that can

legally issue bonds. The corporation has its advantages and disadvantages just like any

other type of company. Some advantages of a corporation include the separation

between management and ownership, the ease with which it is able to transfer

ownership, and the ease it has in raising capital. Alternately, some disadvantages to

consider would be the corporations being subjected to double taxation and the possible

disconnect and subsequent miscommunication between management and the owners.

The current gains yield, capital gains yield, and the yield to maturity for $930 is all

around higher than those for $1,242.30 so the $930 should be accepted so that the

company can gain more profits. Additionally, after analyzing the total assets, long-term

debt, and times-interest earned ratios, it can be concluded that the Dunn’s company

debt position is in good standing because it is above average. This would mean that the

Mutual of Maryville Company should invest in bonds issued by the Dunn Company

above other companies. To add to this, the Mutual of Maryville Company would do well

to choose the bond that is expected to have a 8% declining rate because the present

value would be over $236.61 more than it would sell for at a premium coupon rate of

12%.

Introduction

Bonds are debt securities issued to raise money and are considered relatively

safe investments, but only certain entities can legally issue them. Government entities

and corporations can legally issue bonds in order to borrow money from the public on a
long term basis. Dunn Company has issued bonds for Mutual of Maryville Company to

invest in, therefore we are dealing with a corporation. There are multiple advantages

and disadvantages when dealing with a corporation that need to be considered to see

how it will affect the business.

An advantage of a corporation would be that there is a separation between

management and ownership. This is beneficial because a professional team would

more than likely be more qualified to manage the employees of the company rather than

the owner(s) doing so who could be less qualified. Since the corporation is separate

from the owners the owners are also entitled to limited liability. Another advantage for a

corporation would be that it is fairly easy to transfer the ownership of the corporation

because ownership being divided into shares of stock. This means that whoever has an

ownership in the corporation stock can easily sell their share to the new prospective

owner on the secondary bond market. A last advantage of a corporation is that they can

raise funds from issued bonds and stocks for their business operations.

Even though corporations have many advantages, there are also disadvantages

that need to be considered. Corporations subjected to double taxation. This means that

they will pay taxes on income and taxes on any dividends received. Another

disadvantage to a corporation is possible disconnect between management and the

owners. If there is miscommunication, it will cause ideas and words to be twisted and

cause major confusion among the two parties.

To find the firm’s debt, we need to look at and calculate the debt ratio, times-

earned interest ratio, and fixed charge coverage ratio. First, when calculating the debt

ratio of the company you take the total assets; $282,048,000, minus total equity;
$127,615,000, divided by total assets; $282,048,000, which comes out to be .5475. To

find the times-interest earned ratio you take the long term debt; $97,270,000, divided by

long term debt; $97,270,000 plus total equity; $134,197,000, which equals .4201. Lastly,

to calculate fixed charge coverage ratio you will take the EBIT; $58,599,000 divided by

interest charges; $2,323,000, which equals 25.23.

Once you find the debt, you can conclude the firm’s debt position to see if they

are in good standings or not. The ratios we have calculated came out to be above

average, which is able to pay the borrowed amount available and interest to be paid.

After analyzing the results from the ratios, we can conclude that Dunn’s company debt

position is in good standing because it is above average.

Bond Issue Characteristics

Bonds come in several different varieties and have different features; however,

the key features can be used universally. These key features can affect the financial

availability for a company tremendously as well as help figure how much the company is

in debt. These key features are par/face value, the issuer/bondholder, maturity, and

coupon rate. A bond indenture is a legal document or contract between the bond issuer

and the bondholder that holds the obligations of the issuer to the bondholder. Basically,

a bond is an I.O.U between the lender and borrower that is documented.

The first key feature of a bond is par/face value. Par value, which is also known

as face value, represents the amount of principal that the bondholder will receive at

maturity. Par value is also the value of the bond that is issued at the time the company

or government first sells them. For the most part, the corporate bonds today normally

have a value of $1,000. This may vary depending on the issuer. Next, the bond issuer is
the borrower so that means that the bondholder is the lender. When lending, a

bondholder would want to make sure that the issuer is stable enough to be able to pay

back the bond. For example, the U.S. government or any corporation that is doing quite

well will make the cut. Another key feature of a bond is its maturity. Maturity is the date

when the bond’s principal is due and must be repaid to the lender or bondholder in full.

Although this sounds a little scary, bonds have many different maturity dates. For

example, a typical bond issued could have a maturity of one to five years. Some bonds

may even have a maturity of fifteen to thirty years. The date of maturity is only decided

by the issuer. Lastly, the coupon rate is the interest rate that the issuer agrees to pay

the bondholder. The coupon rate is also known as the yield of a bond. The interest

payments can be paid quarterly (four times a year), semi-annually (twice a year), or can

be paid annually (once a year). Certain bonds don’t have to pay a coupon at all. The

greater the risk of not being repaid, the higher the yield on the bond. The yield is

indicated as a percentage of the face value. For example, a 10% yield on a $1,000 bond

would be a $100 annual payment in interest. Now if the bond had semi-annual

compounding, then one would divide the interest payment by two and if quarterly, the

divide by four.

To determine a bond's value is equal to the present value of its expected future

cash flow. In order to easily find these numbers, one can use a calculator or use a

timeline to help keep the information straight. By using the buttons N (number of years

before maturity), I/Y (interest rate), PV (present value), FV (future value), and PMT

(interest payment), one can easily figure out what they want to know.

Yields
In order to find the current yield, capital gains yield, and total return, the yield to

maturity must be found first. The yield to maturity is the required interest on the bond in

the market if we were to keep the bond until it matures, without selling it before the

maturity date of the bond. The yield to maturity is found using the N, PV, PMT, and FV

to compute the I/Y using the time value of money function on a financial calculator. For

this bond, the number of years to maturity is 10 years, the future value is $1,000, the

present value is $1,000, the payment is $90, which means the yield to maturity equals

9%. The 9% is an annual rate that would be earned by reinvesting the coupon payment

of the bond each year until the maturity date or for 10 years, so the YTM shows what

the future coupon payments will be worth at present value.

The current yield is similar to the YTM, however, it only considers how much

money we would make from investing in the bond and holding it for only one year and

does not factor in the time value of money. To find the current yield, the annual coupon,

or the annual interest multiplied by the price, is divided by the bond price. For this bond,

the interest payment is 9% and the current price is 1,000%, and when multiplied, equals

the annual coupon of $90. The $90 is then divided by the price, or original investment of

$1,000, which then equals 9%. The current yield of 9% aids in deciding whether or not

to invest in the bond because we can expect a 9% return if the bond was held for a

year.

The capital gains yield is the difference between the yield to maturity and the

current yield of an investment. It shows the increase or decrease of the security held

overtime, and then is used to determine how the investment value has changed

because the current yield is only for the first year and the yield to maturity considers the
interest throughout maturity. By subtracting the current yield of 9% from the yield to

maturity of 9%, the capital gains yield for this bond is then equal to 0%, so the

investment value would remain the same over the maturity of the bond.

Finally, the total return uses the current yield and capital gains yield to create a

measurement of the rate of return earned from the investment over a period of usually

one year. For this bond, the total return will equal the current yield of 9% plus the capital

gains yield of 0%. This equals 9% and is a percentage of the initial investment that is

used as an estimate of future returns considering the possible growth or decline from

the capital gains yield found.

A callable bond is a bond that is able to be redeemed before its stated maturity,

and is often done when a company would like to refinance their debt at a lower rate of

interest. The yield to call is then used to find the required interest on the bond if it is held

and then called before maturity, or until the call date. This is found similarly to the yield

to maturity by using the time value of money function on an financial calculator. The

bond with the market value of $930 would have the present value of $930, the future

value of $1,100, the coupon payment of the par value of $1,000 times the required rate

of return of 9% equaling $90, and the number of years until the call date of 5 years. The

yield to call would equal 12.53%. The bond with the market value of $1,242.30 would

have the present value of $1,242.30, the future value of $1,100, the coupon payment of

$90, and the number of years until the call date of 5 years. The yield to call would equal

5.18% for this bond.

Sensitivity Analysis
The present value of a 10-year bond, with $1,000 par value bond, with 9%

annual coupon, if the required rate of return is 9% is equal to $1,000. If the expected

inflation rate from part h rose to a required rate of return of 12%, the value of the new

bond will be equal to a present value of $830.49. This bond would sell at a discount

because the required rate of return 12% is higher than the coupon rate 9%. If the

expected rate declines to 8%, then the amount of the present value would be $1,067.10.

This bond would sell at premium because the required rate of return 8% is lower than

the coupon rate of 9%. The value of a 10 year bond would remain the same if the

required rate of return remained at 12% or 8%. When the coupon rate and the required

rate of return remain constant over the years, the amount would be the same of $1,000.

The value of a discount bond increases $1,000 and the value of a premium decreases

to $1,000.

The yield to maturity on a 10-year 10% annual coupon, $1,000 par value bond

that sells for $930.00 is 11.1985%. When it sells for $1,242.30, the yield to maturity is

6.6118%. When a bond sells at a discount, it means that the market rate is greater than

the coupon rate. When a bond is sold at premium, the market rate is less than the

coupon rate. The current yield for $930 is 10.75%. To solve for the current yield divide

$90, the payment, by the future value of $930 and it is equal to 10.75%.For the current

yield for $1,242.30 is $90 divided by $1,242.30 and is equal to 8.50%. To find the capital

gains yield it is equal to yield to maturity minus current yield. The capital gains yield for

$930 is 11.1985% minus 10.75% is equal to .4485%. The capital gains yield for

$1,242.30 is 6.6118% minus 8.5% is equal to -1.8882%. The total return is current yield

plus capital gains yield. The total return for $930 is 10.75% plus .4485% is equal to
11.1985%. The total return for $1,242.30 is 6.6118% plus -1.8882% is equal to

6.6118%.

The interest rate price risk is the risk of changes in bond prices to investors that

are exposed to the changing interest rates. The bond that has more interest rate price

risk is the 10 year bond. The longer it takes to mature, the greater change in value that

causes the bond to have a higher interest rate price risk. Investment rate risk means

that the risk of payments will have lower rates than today’s rate will be reinvested in the

future. The year that would have more reinvestment rate risk would be a 1 year bond

instead of a 10 year bond. For parts h, i, k, and j have bonds at a semiannual rate

instead of annual coupons. For parts h and i the pv stays the same value of $1,000. For

part k the present value would increase to $1,067.95.

If we were to buy $1,000, either at a 9%, 10 year, annual payment bond or a 9%,

10 year, semiannual payment bond. Both bonds are equally risky. EAR=(1+0.09/2)²-

1=9.2025%. We would prefer the semiannual payment better because the EAR of

9.2025% is better than 9% of the annual payment. Since the risk is the same for both

interest, then we would prefer using the 9.2025% to have the same EAR on the two

bonds. The value of the annual payment using 9.2025% would be $732.69. The value of

of a perpetual bond with an annual coupon of $100 if its required rate of return is 9%

would be 100/.09= $1,111.11. The value of a required rate of return of 12% would be

100/.12= 833.33. The value of a required rate of return of 8% would be 100/.08=

$1,250.

Conclusion
After calculating and comparing the different numerical values from above, the

best recommendation for Mutual of Maryville Company is to invest in Dunn Company.

Since the current yield is 9%, Mutual of Maryville Company can expect this as a return if

it is held for only a year. Once the current yield has been found, the capital gains yield

can be calculated to see how much will be made or loss from this investment. The

current yield came out to be 0%, so the investment value will stay the same over the

maturity of the bond and results in no loss for Mutual of Maryville Company.

In the case of the expected rate declining to 8%, that would be the best choice

because the amount of the present value of 1067.10, is higher since it will sell at a

premium. Mutual of Maryville Company will make more money from this premium bond

than the other options. Also, when choosing between an annual payment bond or semi

annual bond, it would be in Mutual of Maryville’s best interest to choose the semi

annual. This is because the EAR of 9.25% is better than an annual payment of 9%. In

addition, the value of an annual bond of 9.25% is $732.69, compared to the value of a

perpetual bond with a required rate of 9% which equals $1,111.11.

Considering all factors, it is Mutual of Maryville Company’s best interest to invest

in the bonds issued by Dunn Company. From the calculations, it is clear that if they

were to invest in Dunn Company bonds they will be making a profit with little risk to their

company during the life of the bond.

Appendix

Part D
Using the financial statements in appendix to calculate Dunn’s Total Debt Ratio, Long Term
Debt Ratio , Times-Interest-Earned Ratio and Cash Coverage Ratio
Total Debt Ratio = (TA – TE)/T
(282,048,000 – 127,615,000)/282,048,000 = .5475
Long Term Debt Ratio = LTD/(LTD+TE)
97,207,000/(97,207,000+134,197,000) = .4201

Times Interest Earned Ratio = EBIT/Interest


58,599,000/2,323,000 = 25.2256

Cash Coverage Ratio= (EBIT+Depreciation)/Interest


58,599,000 + 2745,000/2,323,000 =26.4072

Part H
What is the value of a 10-year bond with $1,000 par value bond with a 9% annual coupon if its
required rate of return is 9%?
N = 10
I/Y = 9
PMT = 1,000 x .09 = 90
FV = 1,000
PV = 1,000

Part I
What is the yield to maturity, the current yield, the capital gains yield, and the total return of this
bond?
Yield to Maturity
N = 10
FV = 1,000
PV = 1,000
PMT = 90
I/Y = 9%

Current Yield
(1,000 x 9%)/1,000 = 9%

Capital Gains Yield


9% - 9% = 0%

Total Return
9% + 0% = 9%
Part J
Suppose that the bond described in part (h) is callable in 5 years at a call price equal to $1,100.
What is the yield to call (YTC) on the bond if its market value is $930? What is the YTC on the
same bond if its current market price is $1,242.30?
$930
FV = 1,100
PMT = 1,000 x 9% = 90
N=5
PV = 930
I/Y = 12.5250%

$1,242.30
FV = 1,100
PMT = 90
N=5
PV = 1,242.30
I/Y = 5.1790%
Part K
Part 1
What would be the value of the bond described in part (h) if, just after it had been issued, the
expected inflation rate rose by three percentage points, causing investors to require a 12%
return? Is the security now a discount bond or a premium bond?
N = 10
I = 12
PMT = 90
FV = 1,000
PV = 830.4933

Part 2
What would happen to the bond’s value if inflation fell, and return declined to 8%? Would it now
be a premium bond or a discount bond?
N = 10
I=8
PMT = 90
FV = 1,000
PV = 1,067.1008

Part L
Part 1
What is the yield to maturity on a 10-year, 10% annual coupon, $1,000 par value bond that sells
for $930.00? That sells for $1,242.30? What does the fact that a bond sells at a discount or at a
premium tell you about the relationship between rd and the bond’s coupon rate?
$930
N = 10
PV = 930
PMT = 1,000 x 10% = 100
FV = 1,000
YTM = 11.1985%
$1,242.30
N = 10
PV = 1,242.30
PMT = 100
FV = 1,000
YTM = 6.6118%
Part 2
What is the current yield, the capital gains yield, and the total return in each case in question
(j) ,(k) and (l).

J
Current Yield 90/930 = 9.68%

Capital Gains Yield 12.53%-9.68% = 2.85%

Total Return 9.68%+2.85% = 12.53%

Current Yield 90/1,242.30 = 7.24%

Capital Gains Yield 5.18%-7.24% = -2.06%

Current Yield 7.25%+-2.06% = 5.19%

K
Current Yield 90/830.49 = 10.84%

Capital Gains Yield 12%-10.84% = 1.16%

Total Return 10.84%+1.16% = 12%

Current Yield 90/1,067.10 = 8.43%

Capital Gains Yield 8%-8.43% = -.43%


Total Return 8.43%+-.43% = -34.57%

L
Current Yield (1,000x10%)/930 = 10.75%
Capital Gains Yield 11.1985%-10.75% = .4485%

Total Return 10.75%+.4485% = 11.1985%

Current Yield (1,000x10%)/1,242.30 = 8.50%

Capital Gains Yield 6.6118-8.5 = -1.8882%

Total Return 8.5 + -1.8882 = 6.6118%

Part O
Redo parts (h), (i) (j) (k) and (l), assuming that the bonds have semiannual rather than annual
coupons.
H
N = 10x2 = 20
I/Y = 9/2 = 4.5
PMT = 1,000 x .09 = 90/2 = 45
FV = 1,000
PV = 1,000
I
Yield to Maturity
N = 20
FV = 1,000
PV = 1,000
PMT = 45
I/Y = 4.5% x 2= 9%
Current Yield (1,000 x 4.5%)/1,000 = 4.5%
Capital Gains Yield 4.5% - 4.5% = 0%
Total Return 4.5% + 0% = 4.5%
J
$930
FV = 1,100
PMT = 1,000 x 9% = 90/2 = 45
N = 5x2 = 10
PV = 930
I/Y = 6.2118%
$1,242.30
FV = 1,100
PMT = 90/2 = 45
N = 5x2 = 10
PV = 1,242.30
I/Y = 2.6048%
K
N = 10x2 = 20
I = 12/2 = 6
PMT = 90/2= 45
FV = 1,000
PV = 827.951

N = 10x2 = 20
I = 8/2 = 4
PMT = 90/2=45
FV = 1,000
PV = 1,067.95
L
$930
N = 10x2 = 20
PV = 930
PMT = 1,000 x 10% = 100/2 = 50
FV = 1,000
YTM = 11.18%
$1,242.30
N = 20
PV = 1,242.30
PMT = 50
FV = 1,000
YTM = 3.3224%

Part P
Suppose you could buy, for $1,000, either a 9%, 10-year, annual payment bond or a 9%, 10-year,
semiannual payment bond. Both bonds are equally risky. Which would you prefer? If $1,000 is
the proper price for the semiannual bond, what is the proper price for the annual payment bond?
EAR = (1+.09/2)2 -1 = 9.2025%

Part Q
What is the value of a perpetual bond with an annual coupon of $100 if its required rate of return
is 9%? 12%? 8%? Assess the following statement: “Because perpetual bonds match an infinite
investment horizon, they have little interest rate price risk.”
100/.09 = 1,111.1111
100/.12 = 833.3333
100/.08 = 1,250