Bond Valuation Project

Dunn Company

Abagail Moran, Kassidy Jensen, Josh McElwain, Hiba Mahgoub, Dustin Cross, Ourami
Mehdi Zinbi

December 7, 2018
Executive Summary
Dunn Company is a corporation in which we are considering purchasing bonds from. The

Dunn Company, like all corporations, has its positives and negatives. The positives are that a

corporation can easily raise capital, it has unlimited life, it is easy to transfer ownership, and it is

a limited liability company. The negatives of a corporation are the cost of set-up and report

filing, double taxation, and it is a complicated process to manage a corporation. The total debt

ratio was found to be 59.61%, which means the company is in good standings and is a sign that

the Dunn Company could be a safe investment. The total return on the bound was found to be

9% and the yield to call was found to be 12.52%. This means that purchasing Dunn Company

bonds at this time would result in a fair amount of return. For perpetual bonds the interest rate

can affect the value of the bond drastically. With a $100 annual coupon if the required return was

12% the value would be $833.33, and if it was 8% the value would be $1,250. The safest option

at this time would be to invest in the 10 year bonds because they are a more stable and less

sensitive bond.

Introduction
Large corporations and government institutions issue bonds because bond issuance

requires a lot of federal regulations. In this case, the key businesses that are able to issue bonds

are corporations. Since Mutual of Maryville is looking to invest in bonds issued by Dunn

Company, we can conclude that they are a corporation. Since Dunn Company is a corporation,

there is a separation between management and ownership. The owners of the corporation have

limited liability, and the ownership can easily be transferred since they are separate.

Management is very responsive to stockholders because the corporation is separated by the

shares and it’s very easy for them to buy and sell the shares of stock.
 Because Dunn Company has separation between management and ownership as well as

very active stocks, there are quite a few advantages. Since the corporation has separation the

ownership is very easily transferred to new owners, so the life of the corporation is endless as

long as they are in good hands. Another advantage is that since it is a corporation and they can

issue bonds, they can use this to raise money for their business for different things that they may

need. There are a few disadvantages for a corporation as well. One being that since a corporation

is so complex, it takes a lot more work, time, and effort to put it into place. Another disadvantage

would be that since they are a corporation they are taxed twice for their earnings.

Looking at Dunn’s debt position, we evaluate the total debt ratio, the long-term debt

ratio, times-interest-earned ratio, and the cash coverage ratio for the year of 2017. For the total

debt ratio, we took the total assets of $332,218,000 and subtracted total equity which was

$134,197,000 and divided that by the total assets of $332,218,000. The total debt ratio came up

to be 59.61%. When calculating the long-term debt ratio, we took the long-term debt of

$97,207,000 and divided that by the long-term debt plus total equity which was $231,404,000.

The long-term debt ratio was 42.01%. The times-interest-earned ratio is calculated by taking

EBIT and dividing it by the interest. We took $58,599,000 divided by $2,323,000 and got 25.23

times. Lastly the cash coverage ratio is figured by taking the EBIT of $58,599,000 and adding

the depreciation of $2,745,000, then dividing that by the interest of $2,323,000. For the cash

coverage ratio, we got 26.41 times.

In conclusion to our debt findings, we can conclude that Dunn Company is in a pretty

good spot. Since the total debt ratio is only 59.61%, we know that they have a lot more assets

than they do debt. The long-term debt ratio was only 42.01% so that means that less than half of

the assets owned are obligated with loans or debt. Since we got 25.23 for the times interest-
earned ratio, this is favorable because it means the company can meet its debt obligations.

Having a cash coverage ratio of 26.41 times, this is good because the company has enough cash

to meet its needs. Overall, we conclude that the Dunn Company is in good standing.

Bond Issue Characteristics

The key features of a bond are as listed; its par value, maturity, coupon rate, and the

default risk. Other things such as the sinking fund and the call provision are some features as

well. The par value is the actual amount paid at maturity. Maturity is the years that the bond must

be repaid. The coupon rate is the interest rate of the bond. The default risk is the risk of the

interest or principle payment will not be paid. Each feature is important in determining whether

to accept a bond of not. The sinking fund is paying the bond over its life rather than all at

maturity. It is similar to amortization on a bond. Sinking fund reduces risk to investor and

shortens the average maturity.  Another feature is the call provision. That is when the issuer can

refund if the rates decline. Bonds can be called off. Who can issue a bond is also an important

feature. Usually corporations do the issuing. All of these features determine the value of a bond.

There are many ways to determine the value of a bond. One way to determine the value of a

bond is by using the bond value equation. That looks at the present value of the coupon rate and

the present value of the par value. This will show the investor if the bond is worth a lot in the

present state. The value of the bond can also be determined by looking at the yield to maturity.

The yield to maturity is the rate implied by the current bond. Yield to maturity help investors to

determine the value of that bond in those terms. These methods help companies to determine the

value of a bond and whether to accept it or not.

        A ten-year bond with $1000 par value and 9% annual coupon with a required rate of

return at 9%, its present value is $1000. We can see that this bond does not change in value. With

a bond like this, our company would not be losing anything. To determine this bonds value we
took the bond value equation to make a decision. We found the present value of the bond using

the coupon rate and the par value. This helped us to see what the bond is worth now.

Yields
To determine the current yield of this bond, the annual interest payment is divided by the

beginning investment. The annual interest payment will be equal to the interest rate of 9% time

face value of the bond, which is $1,000. This will give us a total of $90 and it will be divided by

current price of $1000. The current yield of the bond will be 0.09 or 9%. This means that if we

buy the bond and hold it for a year; we will approximately earn about 9% of the bond. Having

the current yield will help us to decide if we want to invest. Using the yield to maturity will give

us the anticipated return of the bond if we hold it until it matures and if we do not sell it before

the maturity date of the bond. In addition, to find the yield to maturity, we would need the annual

coupon, interest payment, face value, price, and the years to maturity. The number of years is 10,

the future value is equal to $1,000, and the present value is 1000. To calculate the payment, we

multiply the face value of $1000 times the annual coupon rate of 9%, giving us a payment total

of $90. After having these calculations, the answer for the yield to maturity is equal to 9%.

YTM is an annual rate and will tell us what our future coupons payments are worth at the

present value. All coupons payments are reinvested at the same rate as the bond's current yield of

9%. In addition, capital gains yield refers to the security's appreciation or depreciation during the

time it is held. The capital gains yield is important in order for us to figure out the change in our

investment value. The formula for capital gains yield is equal to yield to maturity minus current

yield. As said before, the yield to maturity and the current yield are both equal to 9%. The capital

gains yield is 1,000 minus 1,000, which is equal to 0. The total return measures the rate of return

earned from an investment over a period by combining interest, capital gains, dividends, and

distributions. Total returns are usually measured over one year and it is a percentage of the initial
investment. To find the total return, the following formula will be used, total return is equal to

current yield plus capital gains yield. As we said before, current yield is equal to 9% and the

capital gains yield is equal to 0. The total return is 9% plus 0%, which is equal to 9%.

The yield to call is used when you purchase and hold a security until the call date.

However, the yield is only effective when the security is called before maturity. To calculate the

yield to call on the bond, it is necessary to have the coupon, current market price, call price, and

the years until call date. For our bond, the coupon was at 10% with a par value of $1000. When

multiplying, these two will be the annual coupon payment. The current market price for our bond

is at $930. The call price, which is the price that must be paid on the first call date, is at $1100,

with a 5 year until call date. This will give us a YTC of 12.52%. If the market price would

change to $1,242.30, then the YTC will decrease to 5.18%. See appendix h and i for the answer.

Sensitivity Analysis
Changes in the interest rate of the bond will have a profound impact; this is because the

interest rate is critical for the calculation of a bonds value.  However, the change brought about

by the interest rate is also based upon the coupon rate. If a 10 year bond with a $1,000 face

value with an annual coupon rate of 9% has a required return of 9% it will have a present value

of $1000, as it would be par.  However, if the bond had a required return of 12% it would result

in a present value of $830.49, which would be a discount. This is caused by the fact that the

required rate is greater than the coupon rate. The similar, but opposite is true for if the required

rate decreased to 8% with a present value of $1,067.10 which would result in a premium.  The

bond can also have its value affected by a change in interest rates; this causes the interest rate

price risk. The risk in changing interest rates increases with time meaning that longer-term

bonds will have a higher risk than short-term bonds. This means that a 10 year bond has a higher

interest rate price risk than a 1 year bond. The effects of the interest rate price risk is, however,
somewhat mitigated or entirely overturned by the reinvestment rate risk, which is the risk that an

investor will have to take the principle from previous investment and reinvest them at a lower

rate.

A bond is also sensitive to the rate of coupon payments. This would be due to the

compounding of rates caused by multiple coupon payment and interest periods.  For example

while our 10-year, $1000 face value, 9% coupon, with annual payment and thus an effective rate

of 9% would hold a present value of $1000, the same bond but with semi-annual payments, thus

an EAR of 9.2%, would hold a present value of $987.28.  This amount would be considered a

discount when compared to the annually paying version of the bond. The value of a perpetual

bond with an annual coupon of $100 and a required rate of return of 9% would be $100 / .09=

$1,111.11, with 12% it would be $100/.12 = $833.33, and 8% would be $100/.08= $1,250. See

appendix j-q for answers.

Conclusion
After comparing the bond’s different yields, inflation, company risk, interest rate risk,

maturity, and coupon payment, we recommend that Mutual of Maryville invests in Dunn

Company’s bonds. Specifically, Mutual of Maryville should invest in the bond that has a market

rate of $930, a coupon payment of $90, an interest of 12.52%, a yield to call of 5 years, and a

face value of $1,100. This will earn Mutual of Maryville about 9.68% of the bond. When

evaluating capital gains yield, this bond has a gain of 18.28%. Furthermore, our decision to

invest in this bond is confirmed because the yield to maturity of this bond is 11.2%. Lastly, when

comparing total returns, this bond of $830.49 has the highest total return of 27.96%.

Inflation also plays a role in deciding whether or not to accept a bond. If the inflation rate

rose from 9% (part h) to 12% (part k), then the bond would be issued at a discount. The bond

price would fall from $1,000 to $830.49. If the inflation rate fell from 9% (part h) to 8% (part k),
then the bond would be issued at a premium. The bond price would rise from $1,000 to

$1,067.10. Mutual of Maryville should choose to take the increased inflation rate because they

will have to pay Dunn Company less, since the bond is issued at a discount.

Another component in deciding whether to accept a bond is interest rate risk. Mutual of

Maryville should choose to invest in Dunn Company’s bonds with a shorter maturity because the

longer the maturity, the higher the interest rate risk is. Since Dunn Company is in good

standings, and after comparing yields, inflation, interest rate risk, maturity, and coupon payment,

we can conclude that Dunn Company is a good company for Mutual of Maryville to invest in.

Appendix
Part D)
2017: Total Debt Ratio= (Total Assets - Total Equity) / Total Assets
= (332,218,000 - 134,197,000) / 332,218,000
= 198,021,000 / 332,218,000
= .59606 = 59.61%
Long Term Debt Ratio= Long Term Debt / (Long Term Debt + Total Equity)
= 97,207,000 / (97,207,000 + 134,197,000)
= 97,207,000 / 231,404,000
= .42007 = 42.01%
Times-Interest-Earned Ratio  = EBIT / Interest
= 58,599,000 / 2,323,000
=25.23 times
Cash Coverage Ratio  = (EBIT + Depreciation) / Interest
= (58,599,000 + 2,745,000) / 2,323,000
=61,344,000/2,323,000
=26.41 times
2016: Total Debt Ratio =  (282,048,000 - 127,615,000) / 282,048,000
= .54754 = 54.75%
Long Term Debt Ratio= 75,427,000 / (75,427,000 +127,615,000)
= 75,427,000 / 203,042,000
= .37148 = 37.15%
Times-Interest-Earned Ratio= 46,401,000/1,456,000
=31.87 times
Cash Coverage Ratio= (46,401,000+1,348,000) / 1,456,000
         = 47,749,000 / 1,456,000
         = 32.79 times
Part H)
N= 10; I/Y= 9%; PMT= 9% x 1,000= 90; FV= 1,000; CPT PV= $1,000
Part I)
YTM= N = 10; PMT = 9; PV = -1,000; FV= 1,000; CPT YTM = 9%
Current Yield= Annual Coupon/Price= 90 / 1,000 = .09 = 9%
Capital gain yield= (future price - price today) / price today= (1,000 - 1,000)/ 1,000= 0%
Total return= current yield + capital gain= 9% + 0% = 9%
Part J)
Market value is $930: YTC= N=5; FV= 1,100; PV= 930; PMT=90; CPT I/Y= 12.52%
Market price is $1,242.30: YTC= N=5; FV= 1,100; PV=1,242.30; PMT=90; CPT I/Y = 5.18%
Part K)
1. N=10; FV= 1,000; PMT= 90; I/Y= 12%; CPT PV= $830.49; discount
2. N=10; FV=1,000; PMT=90; I/Y= 8%; CPT PV = $1,067.10; premium
Part L)
1. Bond that sells for $930.00:
YTM= N = 10; PV= -930; FV = 1,000; PMT = 10% x 1,000 = 100; CPT I/Y= 11.20%
That sells for $1,242.30:
YTM = N = 10; PV= -1,242.30; FV = 1,000; PMT= 100; CPT I/Y= 6.61%
2. Current Yield (J1) = 90 / 930 = 0.0968= 9.68%
Capital Gains Yield (J1)= (1,100 - 930) / 930 = .1828= 18.28%
Total Return (J1)= 9.68%% + 18.28% = 27.96%
Current Yield (J2) = 90 / 1,242.30 = .07245 = 7.25%
Capital Gains Yield (J2)= (1,100 - 1242.30) / 1,242.30= -.011455 = -1.15%
Total Return (J2)= 7.25% -1.15% = 6.1%
Current Yield (K1)= 90/830.49= .10837 = 10.84%
Capital Gains Yield (K1)= (1,000-830.49)/830.49= .20411= 20.41%
Total Return (K1)= 10.84% +20.41% = 31.25%
Current Yield (K2)= 90/1,067.10= .0843=8.43%
Capital Gains Yield (K2)= (1,000-1067.10)/ 1067.10 = -.06288 = -6.29%
Total Return (K2)= 8.43% - 6.29% = 2.14%
Current Yield (L1)=  100/ 930 = .10753 = 10.75%
Capital Gains Yield (L1)= (1,000 - 930) / 930 = .07527 = 7.53%
Total Return (L1)= 10.75% + 7.53% = 18.28%
Current Yield (L2)=  100/1,242.30= .0805 = 8.05%
Capital Gains Yield (L2)= (1,000-1,242.30)/1,242.30= -.19504 = -19.50%
Total Return (L2)=8.05% - 19.50% = -11.45%
Part O)
H redone) N= 10 x 2 = 20 ; I/Y= 9% / 2 = 4.5%; PMT= (9% x 1,000)/ 2= 45; FV= 1,000; CPT
PV= $1,000
I redone)
YTM= N = 10 x 2= 20; PMT = 90 / 2= 45; PV = -1,000; FV= 1,000; CPT YTM = 4.5%
Capital Gains Yield= (1,000 -1,000)/1,000 = 0%
Current Yield= 45/1,000 = .045 = 4.5%
Total Return= 0% + 4.5% = 4.5%
J Redone)
1. YTC= N=5 x 2= 10; FV= 1,100; PV= 930; PMT=90/2 = 45; CPT I/Y= 6.21% x 2 =12.42%
2. YTC= N=5 x 2=10; FV= 1,100; PV=1,242.30; PMT=90/2 = 45; CPT I/Y = 2.60% x 2= 5.20%
K Redone)
1. N=10 x 2= 20;  FV= 1,000; PMT= 90/2= 45; I/Y= 12% / 2=6%; CPT PV= $827.95
 2. N=10 x 2= 20;  FV=1,000; PMT=90/2=45; I/Y= 8% / 2=4%; CPT PV = $1,067.95
L Redone)
1. A. YTM= N = 10 x 2= 20; PV= -930; FV = 1,000; PMT = (10% x 1,000) / 2 = 50 ; CPT
I/Y= 5.59% x 2= 11.18%
B. YTM = N = 10 x 2=20; PV= -1,242.30; FV = 1,000; PMT= 100/2=50; CPT I/Y= 3.32
x 2= 6.64%
Part P)
9% annual bond vs. 9% semiannual bond:
Semiannual EAR= (1 + .09/2)^2 - 1= .092= 9.2%
9.2% > 9% on annual, so should buy semiannual
Proper price for annual payment bond:
N = 10; I/Y= 9%; PMT= 1,000 x 9.2%= 92; FV= 1,000; CPT PV= $1,012.84
Part Q)
Required rate of return is 9%: 100 / .09= $1,111.11
12%: 100/.12 = $833.33
8%: 100/.08= $1,250
Group Participation
For this group project, our team did a good job of working together. Every individual had

a part in the writing of the paper and in doing the calculations. Each person took a portion of the

paper and wrote about a page. Hiba did the bond characteristic part and wrote a page of the

paper. Josh wrote the executive summary. He did a great job summarizing the entire project.

Kassidy wrote the introduction. She included a review of the financial health of the company.

This was a good starting point to our report. Ourami wrote the section on yields. He interpreted

the values of the current yield, yield to maturity, yield to call, the capital gains yield and the total

return of the bond issue. Dustin wrote the sensitivity analysis. He explain how interest rate,

inflation, and interest reinvestment rate risk affect a bond. Abagail finished off our project by

writing the conclusion. She gave recommendations based on the different characteristics of the

bonds. Everyone in the group wrote a portion of this project for it all to come together.

Our team also did a great job working together on the Appendix. We met together

multiple times to get this done. Each person worked on the same problem to ensure that we all

got the same answer. It came together really well in the end. There were not any conflicts with

our team meetings. We all showed up on time and did not waste any time doing the work. After

submitting the calculations and getting feedbacks, we all came together to fix our mistakes.

Overall, everyone put in the same effort.