Reference no: EM132751082

Question - CASE ANALYSES

Q1) You are the Vice-President of Mayan Corporation, a financing company. You plan to invest the company funds in long-term bonds. You have P600 million to invest in. You may purchase highly rated municipal bonds at par with a coupon rate of 6%. Moreover, you also have a choice of maturity between 10 years or 20 years. Alternatively, you could purchase highly rated corporate bonds at par with a coupon rate of 8%. These bonds also are offered with maturities of 10 years or 20 years. You do not expect to need the funds for five (5) years. At the end of the fifth year, you will sell the bonds because you will need to make a large purchase at that time.

a. What is the annual interest you would earn, before taxes, on the municipal bond? On the corporate bond?

b. If the level of credit risk and the liquidity for the municipal and corporate bonds are the same, would you invest in the municipal bonds or the corporate bonds? Why?

Q2) To satisfy the demand, Ericson Company may need to increase its production capacity by about 50% over the next few years. It would need financing to expand and accommodate the increase in production. It considers issuing stock or bonds to raise the capital next year. The yield curve is currently upward sloping.

At a recent meeting of the board of directors, the chief executive officer (CEO) stated his view that the economy will remain strong. So, he wants to expand the business to benefit from the expected increase in demand for Ericson's products. The chief financial officer (CFO) stated that if Ericson Company needs to obtain long-term funds in financing the expansion plan, the issuance of fixed-rate bonds would be ideal at this point. The government has been accelerating its infrastructure projects which resorted to more borrowings. Government debt to GDP has risen from 40% to 50% in one (1) year. Because of this, the CFO expects interest rates to increase in 12 months.

a. If the CFO is correct about future interest rates, what does this suggest about the need to issue bonds?

b. What may be the possible reasons why interest rates may remain low despite aggressive government borrowings?

c. At the meeting, the CEO said, "The decision to expand should not be dictated by whether interest rates are going to increase or not. Bonds should be issued only if the potential increase in interest rates is attributed to strong demand for loanable funds rather than the BSP's reduction in the supply of loanable funds." What does this statement means?