Reference no: EM131821512
After carefully conducting a yield analysis on Kaufman Enterprises current bonds, I am presenting a report in favor of calling the bond earlier than the 10 years maturity date and exchanging them with newly issued bonds. The report will also show that Kaufman will be able to save money by doing so. The findings will be provided below along with an addendum that shows the results of the analysis.
There is an inverse relationship between Bond prices and interest rates. As interest rates rise, the bond prices decline and then reciprocates. Coupons on bonds issued in the past are lesser than newly issued bonds. The demand decreases for previously issued bonds which decrease prices in comparison to newly issued bonds.
Yield-to-maturity (YTM) on bonds that are acquired at present market prices which were previously acquired, are parallel to the market rate of interest and interchanges in same fashion as the interest rate. As interest rates increase, YTM will increase. The same will occur if interest rates decrease. YTM has an antithetical relationship with bond prices and increases with drop in bond prices and then vice versa. At best, the bond trading will have an YTM lesser than the coupon rate and the same when reversed.
Yield-to-call (YTC) operates in similar fashion. The issuing entity can tag bonds in which they are uncertain with a call option. The give the company the call option at the preference of issuing firm. In his situation, the company will not have option to utilize the bond until its maturity. The yield produced on this bond that is held until the callable period is called as Yield to Call.
The advantage of the call option is that if the current rate of interest drops below coupon rate of the bond that were previously issued, new bonds can be issued at lower rate. The old bond can be retired, which could save money on interest.
After careful analysis, we see that the bonds issued to Kaufman were issued at 11%. The maturity date is at 10 years. There is a call option of 5 years with a best of 109%. The original value of the bond is $1,000 with a current value of $1,175. The Yield to Call is 8.13%. The value today is 8.35%. After the maturity of 10 years it is at 8.13%. If Kaufman does not call the bond, the coupon will continue at 11%, which is a higher rate.
It is clear that it is best to call the bonds between years 5 to year 9. The Yield to Call is between 8.13% to 8.53%. The Yield to Maturity is 8.35%. This means that rates would be lower than the original 11%. Kaufman has the call option each year after year 5. The rate of decline is 1% each year, which makes year 5 the best to call. If the bonds are called at year 5 and interchanged with new bonds, the company will save on interest. The yield to call would be 8.13%.
Other financial options are long term loans. There are advantages and disadvantages to long term loans instead of bonds. Advantages include that loans may have better interest rates. Their payment plan may be flexible. This elasticity is not available with bonds. Bonds have terms that may not be flexible or conducive to the company’s needs. The bond holder may not be able to finagle the terms of the bond. The cost of the bond is also usually higher than a loan. A disadvantage of loan is that the bond’s rate is fixed while a loan’s rate can vary depending on the market.