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Coupon Bearing Bonds vs. Zero Coupon Bonds

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Dan is considering whether to issue coupon bearing bonds or zero coupon bonds. The YTM on either bond issue will be 7.5%. The coupon bond would have a 6.5% percent coupon rate. The company's tax rate is 35%. These are 20 year bonds.

2. How many of the coupon bonds must East Coast issue to raise the $50 million?

3. In 20 years, what will be the principal repayment due if East Coast Yachts issues the coupon bonds? What if it issues the zeroes?

4. What are the company's considerations in issuing a coupon bond compared to a zero coupon bond?

5. Suppose East Coast Yachts issues the coupon bonds with a make-whole call provision. The make-whole call rate is the treasury rate plus .40 percent. If East Coast calls the bonds in seven years when the Treasury rate is 4.8%, what is the call price of the bond? What if it is 8.2%?

6. Would you recommend a zero coupon issue or a regular coupon issue? Why? Would you recommend an ordinary call feature or a make-whole call feature? Why?

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Solution Summary

Coupon bearing bonds versus the zero coupon bonds are examined. Whether the principal repayment is due is determined.

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High-Yield Securities and Risk for Stephanie

Stephanie is an investor who is willing and able to bear substantial risk in order to earn a higher return. As her financial planner, you believe that high-yield debt instruments would be an attractive alternative to stocks, whose prices have risen recently. High-yield securities offer larger returns but may involve substantial risk. The combination of high risk and high return are consistent with her investment philosophy so you suggest the following B-rated bonds:

Maturity Date Yield to
Company Coupon (Years) Price Maturity
A 10% 10 $900 11.75%
B 15% 15 1,200 12.055
C 0 7 487 10.825
D 7 10 772 10.847

In addition, she also wants you to compare the bonds' price volatility with the triple-A rated bonds with the same terms to maturity. The four triple-A rated bonds are as follows:

Maturity Date Yield to
Company Coupon (Years) Price Maturity
E 6.5% 10 $900 7.99%
F 10.5% 15 1,200 8.143
G 0 7 587 7.908
H 4.5 10 772 7.879

Questions:

1. If interest rises by 3 percent across the board, what will be the new price of each of the eight bonds?

2. What do these new prices suggest about the price volatility of high-yield versus high quality bonds?

3. Which bond prices were more volatile?

4. If two bonds with the same term to maturity sell for the same price, which bond may subject the investor to more interest rate risk?

5. Does acquiring bonds with higher credit ratings and less default risk also imply the investor has less interest rate risk?

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