Case study:

Evaluating Fatimas Proposed Investment

in Specialized Investment Compounds Co. Bonds

Fatima is considering investing in Specialized Investment Compounds Co bonds. Specialized Investment Compounds Co. bonds were sold at $1,000 par value 5 years ago and had precisely 25 years to mature. They have an 8% interest rate coupon, are convertible into 50 common stock shares, and can be called at $1,080 anytime. Moody's graded the bond Aa. Specialized Investment Compounds Co., a sports goods maker, recently acquired a small, financially troubled athletic-wear business. Following the purchase, Moody's and other rating agencies consider a rating change for Specialized Investment Compounds Co. bonds. Recent economic data show that inflation, currently at 5% annually, is expected to rise to 6% annually.

Fatima remains interested in the Specialized Investment Compounds Co. bond, but she is concerned about inflation, future interest rate change, and maturity risk. To get an understanding of the possible effect of these variables on the bond value, she wanted to apply the valuation techniques she learned in her financial course.

Required

a. If the price of the common stock into which the bond is convertible rises to $30 per share after 5 years and the issuer calls the bonds at $1,080, should Fatima let the bond be called away from her or should she convert it into common stock?

b. For each of the following required returns, calculate the bonds value, assuming annual interest. Indicate whether the bond will sell at a discount, at a premium, or at par value.

• 6% Required return.
• 8% Required return.
• 10% Required return.

c. Repeat the calculations in part b, assuming that interest is paid semiannually and that the semiannual required returns are one-half of those shown. Compare and discuss differences between the bond values for each required return calculated here and in part b under the annual versus semiannual payment assumptions.

d. If Fatima strongly assumes inflation will increase by 1% over the next 6 months, what is the most she can pay for the bond, assuming annual interest?

e. If the Specialized Investment Compounds Co. bonds are downrated by Moodys from Aa to A, and if such a rating change will increase the required return from 8% to 8.75%, what impact will this have on the bond value, assuming annual interest?

f. If Fatima buys the bond today at its $1,000 par value and holds it for exactly 3 years, at which time the required return is 7%, how much of a gain or loss will she experience in the value of the bond (ignoring interest already received and assuming annual interest)?

g. Rework part f, assuming that Fatima holds the bond for 10 years and sells it when the required return is 7%. Compare your finding to that in part f, and comment on the bonds maturity risk.

h. After evaluating all the issues raised above, what recommendation would you give Fatima about her proposed investment in the Specialized Investment Compounds Co. bonds?

Note: You can use Financial tables for answering the required questios