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Abbott Labs Bond Issues; Forecasted Prices of Capital Stock

1. In the past, Abbott Labs had two bond issues outstanding with the following characteristics:

Issue Interest Rate Maturity Current Price
A 6% 2008 115
B 6% 2012 118

a) Which issue, A or B, has the higher effective rate of interest? How can you tell?
b) Assume that the bonds of both issues have face values of $1,000 each. How much total interest does each bond from issue A provide investors in 12 months? How much total interest does each bond from issue B provide investors in 12 months?
c) Note that both issues are by the same company, have the same contract rate of interest, and have identical credit ratings. In view of these facts, explain the current price difference of each issue.

2. ADM Labs is a publicly owned company with several issues of capital stock outstanding. Over the past decade, the company has consistently earned modest profits and has increased its common stock divided annually by 5 or 10 cents per share. Recently the company introduced several new products that you believe will cause future sales and profits to increase dramatically. You also expect a gradual increase in long-term interest rates from their present level of about 11 percent to perhaps, 12 percent to 12ΒΌ percent.

On the basis of these forecasts, explain whether you would expect to see the market prices of the following issues of ADM capital stock increase or decrease. Explain your reasoning in each answer.

a) 10 percent, $100 par value preferred stock (currently selling at $90 per share).
b) $5 par value common stock (currently paying an annual dividend of $2.50 and selling at $40 per share.)
c) 7 percent, $100 par value convertible preferred stock (currently selling at $125 per share).

Solution Preview

Please see the attached file for the complete tutorial.

Question 1a
A has the higher effective rate. I can tell because it is selling at a lower price
The lower the price, the higher is the effective rate of the bond.

Question 1b
Issue A B
Interest rate 6% 6%
Interest payment $60.00 $60.00

Question 1c
The price difference is due to the different time to maturity. Issue A is maturing
earlier than ...

Solution Summary

The solution discuses Abbott Labs two bond issues and the forecasted prices of capital stock.