Please answer question 3-11.

Babes-N-Toyland Interest Rate Forecasting and Financial Strategy Wally Ligenfelt, Vice President for Economic Planning at Babes-N-Toyland, absolutely hated January. After the Christmas selling season ended, sales at Babes-N-Toylandan up- scale retail chain of toy and infant supply stores--plummeted. In addition, January meant that it was time for him to begin preparing the annual forecast of macroeconomic condi- tions for use by the firm's strategic planners. As a five-year veteran of Babes-N-Toyland's management team, Wally realized he needed to get this report finished in a hurry, because the marketing department would soon be calling to request his assistance in forecasting sales and inventory levels for the coming year. Before turning to the day's work, Wally glanced through his stack of Monday- morning mail in hopes of finding something to cheer him up. What he found, however, caused him to roll up his sleeves, forget about his routine plans for the day, and plunge into his work. It was the following memo from his boss, Abigail Fortenbury, the President of Babes-N-Toyland: Babes-N-Toyland 791 Case 1 it 1 To: Babes-N-Toyland Internal Correspondence Personal and confidential (Do not duplicate) W. Liperfalt, Economie Planning From: A. Fortenbury, President Date: January 7, 1983 Subject: Corporate Strategy Changes As you know, Babes.N.Toyland just concluded a banner year. After our targest national rival, Child World Inc., closed its doors forever last year, and Lionel Corporation entered Chapter 11 bankruptcy protection, our market share advanced to 20 percent of the $15 billion toy market. While this is indeed good news for our entre organization, we face some new, potentially devastating challenges in the year ahead Reviewing the monthly profit-and-loss figures I just received from Ba Sheckland in Accounting. I that our operating margin has fallen from its customary 14 percent to a little over 10 percent. The entry of discount merchants into our major market aros particularly Wal-Mart, Kmart, and Target storos--forced many of our retail outlets to reduce transaction prioos during the holiday selling season. Because we compete head-to-head with these retail plants in practically all of our prime geographic locations, we must take drastic action in the coming year to defend our market share. Over the holidays, I met with Brad Hinkle and several other members of the Board of Directors to discuss this threat. Based on our discussions, wo plan to implement several strateglo changes at Babes-N-Toyland in the coming year, including: 1. Broadening our product line 2. Aaturbishing our domestic retail outlets. 3. Expanding our base of retail stores in Europe and Asla. 4. Reducing our corporate headquarters statt. In order to prepare for a special meeting of the Board on Monday, January 10, I need the fotlowing information from your office 1. Yield curve data and analysis, showing the trends in Interest rates over the last few years along with an explanation of these trends 2. Information conceming the stability ot current prices, and the rate of inflation that we will key face over the next several years. 3. Your analysis regarding debt issuance by Babos-N-Toyland. Specifically, is the timing right for our organization to undertake significant capital projects financed with debt? The Board realizes we nood a quick response to the competitive threat I outlined above. They will probably suggest that we flout a rather large bond issue to fund these changes. Based on my proliminary discussions with our underwriters, I think we can currently issuo 3-year bonds priced to yield 6.4 percent per annum; 5-year bonds priced to yield 7.3 percent, and 10-year bonds priced to yield 8.4 percent. Before I begin serious negotiations with the underwriters, however, I want our in house analysis team to give me a thorough overview of current credit conditions in the debt market Please call my secretary and set up a meeting with me on Thursday, January 14. Bring the Information requested above to our meeting, and be prepared to answer some of my questions as prepare for the Board meeting on the 19th. 2 Cases able 1 November 1992 Treasury Security Yields August Maturity 1991 3 months 5.33% 6 months 5.39 1 year 5.78 2 years 6.43 3 years 6.BD 4 years 7.23 5 years 7,43 5 years 7.51 7 years 7.74 8 years 7.79 9 years 7.88 10 years 7.90 30 years 8.14 August 1992 3.18% 3.21 3.47 4.19 4.72 4.86 5.60 5.87 6.12 6.32 6.47 6.59 7.39 3. 20% 3.43 3.80 4.65 5.22 5.72 6.12 6.34 6.56 6.87 8.95 7.18 7.53 Souca Federal Reserve Buset, various issues With little more than a week to prepare his report, Wally quickly got to work. He called the economic data shown in Table 1 up on his computer, and used this information to prepare a quick estimate of the market risk premia shown in Table 2. As he began work ing, he couldn't stop thinking about the fourth item in Fortenbury's list of pending changes: administrative staff reductions--why, that could mean his position, and his department Wally knew it was high time to demonstrate his value at Babes-N-Toyland by responding to his boss' request with timely information and insightful analysis. le 2 Babes-N-Toyland, Inc.: Risk Premia Information for Fixed-Income Securities, December 27, 1992 DEFAULT RISK PREMIA Maturity Risk Liquidity Risk AAA-Rated B-Rated C-Rated Maturity Premia Premia Bonds Bonds Bonds 3 months 0.0% 0.0% 0.9% 1.8% 3.1% 6 months 0.0 0.0 0.9 1.8 3.1 1 year 0.0 0.0 0.9 1.B 3.1 2 years 0.2 0.0 0.9 1.8 3.1 3 years 0.3 0.1 0.9 1.8 4 years 0.5 0.1 0.9 1.8 3.1 5 years 0,6 0.2 0.9 1.B 3.1 6 years 0.7 0.2 0.9 1.B 3.1 7 years 0.7 0.3 0.9 1.8 3.1 8 years 0.7 0.3 0.9 1.8 3.1 9 years 0.8 0.3 0.9 1.8 3.1 10 years 0.8 0.4 0.9 1.8 3.1 3.1 Case 1 Babes-N-Toyland 793 ESTIONS 1. Using the data provided in Table 1. construct the yield curves for August 1991, August 1992. and November 1992 2. Evaluate the change in the shape of the yield curve between (2) August 1991 and August 1992, and (b) August 1992 and November 1992 using expectations theory and market segmentation theory 3. Calculate the one-year forward rates of interest implied by the November 1992 yield curve over the period 1993-2002 4. Using the one-year forward rates obtained in Question 3, calculate the expected annual inflation rate in each of the next ten years, and use this information to obtain the average rate of price ap preciation expected over the 1993-2002 period. In your calculations, assume a strict expecy tions theory approach to nominal interest rate construction, where kok + Expected inflation premium 5. Examine the information provided in Table 2. Do these data lead you to believe that the annual inflation rates you calculated in Question 4 might be incorrect? Why or why not? 6. Using the data provided in Tables 1 and 2 prepare a revised estimate of (a) the one-year for ward interest rates implied by the November 1992 yield curve over the 1993-2002 period; and (b) the expected annual inflation rate in cach of these years. 7. How would the yield curve for (a) an AAA-rated firm, (b) a B-rated firm, and (c) a Crated firm, differ from the Treasury security yield curve you constructed in Question 17 Plot the individual yield curves for each of these risky securities to demonstrate your answer. 8. In Question I you constructed a serics of yield curves using Treasury security yields, while in Question 7 you constructed yield curves using the term structure of interest rates for various classes of risky debt. In most cases, financial analysts prefer the former approach to yield curve construction. Why is it better to construct the yield curve using the term structure of returns drawn from Treasury securities rather than risky corporate bonds? 9. Can you use the information provided in the case to estimate Babes-N-Toyland's bond rating? If so, identify this rating, and explain how you obtained it 10. If Babes-N-Toyland issues 10-year corporate bonds to fand its expansion plans and these bonds are priced to sell at par in the market, what is the semi-annual coupon payment that the firm must offer its bondholders? 11. Based on your answers to Questions 1 through 10. is now a good time for Babos-N-Toyland to issue a large quantity of long-term debt securities? Why or why not? Babes-N-Toyland Interest Rate Forecasting and Financial Strategy Wally Ligenfelt, Vice President for Economic Planning at Babes-N-Toyland, absolutely hated January. After the Christmas selling season ended, sales at Babes-N-Toylandan up- scale retail chain of toy and infant supply stores--plummeted. In addition, January meant that it was time for him to begin preparing the annual forecast of macroeconomic condi- tions for use by the firm's strategic planners. As a five-year veteran of Babes-N-Toyland's management team, Wally realized he needed to get this report finished in a hurry, because the marketing department would soon be calling to request his assistance in forecasting sales and inventory levels for the coming year. Before turning to the day's work, Wally glanced through his stack of Monday- morning mail in hopes of finding something to cheer him up. What he found, however, caused him to roll up his sleeves, forget about his routine plans for the day, and plunge into his work. It was the following memo from his boss, Abigail Fortenbury, the President of Babes-N-Toyland: Babes-N-Toyland 791 Case 1 it 1 To: Babes-N-Toyland Internal Correspondence Personal and confidential (Do not duplicate) W. Liperfalt, Economie Planning From: A. Fortenbury, President Date: January 7, 1983 Subject: Corporate Strategy Changes As you know, Babes.N.Toyland just concluded a banner year. After our targest national rival, Child World Inc., closed its doors forever last year, and Lionel Corporation entered Chapter 11 bankruptcy protection, our market share advanced to 20 percent of the $15 billion toy market. While this is indeed good news for our entre organization, we face some new, potentially devastating challenges in the year ahead Reviewing the monthly profit-and-loss figures I just received from Ba Sheckland in Accounting. I that our operating margin has fallen from its customary 14 percent to a little over 10 percent. The entry of discount merchants into our major market aros particularly Wal-Mart, Kmart, and Target storos--forced many of our retail outlets to reduce transaction prioos during the holiday selling season. Because we compete head-to-head with these retail plants in practically all of our prime geographic locations, we must take drastic action in the coming year to defend our market share. Over the holidays, I met with Brad Hinkle and several other members of the Board of Directors to discuss this threat. Based on our discussions, wo plan to implement several strateglo changes at Babes-N-Toyland in the coming year, including: 1. Broadening our product line 2. Aaturbishing our domestic retail outlets. 3. Expanding our base of retail stores in Europe and Asla. 4. Reducing our corporate headquarters statt. In order to prepare for a special meeting of the Board on Monday, January 10, I need the fotlowing information from your office 1. Yield curve data and analysis, showing the trends in Interest rates over the last few years along with an explanation of these trends 2. Information conceming the stability ot current prices, and the rate of inflation that we will key face over the next several years. 3. Your analysis regarding debt issuance by Babos-N-Toyland. Specifically, is the timing right for our organization to undertake significant capital projects financed with debt? The Board realizes we nood a quick response to the competitive threat I outlined above. They will probably suggest that we flout a rather large bond issue to fund these changes. Based on my proliminary discussions with our underwriters, I think we can currently issuo 3-year bonds priced to yield 6.4 percent per annum; 5-year bonds priced to yield 7.3 percent, and 10-year bonds priced to yield 8.4 percent. Before I begin serious negotiations with the underwriters, however, I want our in house analysis team to give me a thorough overview of current credit conditions in the debt market Please call my secretary and set up a meeting with me on Thursday, January 14. Bring the Information requested above to our meeting, and be prepared to answer some of my questions as prepare for the Board meeting on the 19th. 2 Cases able 1 November 1992 Treasury Security Yields August Maturity 1991 3 months 5.33% 6 months 5.39 1 year 5.78 2 years 6.43 3 years 6.BD 4 years 7.23 5 years 7,43 5 years 7.51 7 years 7.74 8 years 7.79 9 years 7.88 10 years 7.90 30 years 8.14 August 1992 3.18% 3.21 3.47 4.19 4.72 4.86 5.60 5.87 6.12 6.32 6.47 6.59 7.39 3. 20% 3.43 3.80 4.65 5.22 5.72 6.12 6.34 6.56 6.87 8.95 7.18 7.53 Souca Federal Reserve Buset, various issues With little more than a week to prepare his report, Wally quickly got to work. He called the economic data shown in Table 1 up on his computer, and used this information to prepare a quick estimate of the market risk premia shown in Table 2. As he began work ing, he couldn't stop thinking about the fourth item in Fortenbury's list of pending changes: administrative staff reductions--why, that could mean his position, and his department Wally knew it was high time to demonstrate his value at Babes-N-Toyland by responding to his boss' request with timely information and insightful analysis. le 2 Babes-N-Toyland, Inc.: Risk Premia Information for Fixed-Income Securities, December 27, 1992 DEFAULT RISK PREMIA Maturity Risk Liquidity Risk AAA-Rated B-Rated C-Rated Maturity Premia Premia Bonds Bonds Bonds 3 months 0.0% 0.0% 0.9% 1.8% 3.1% 6 months 0.0 0.0 0.9 1.8 3.1 1 year 0.0 0.0 0.9 1.B 3.1 2 years 0.2 0.0 0.9 1.8 3.1 3 years 0.3 0.1 0.9 1.8 4 years 0.5 0.1 0.9 1.8 3.1 5 years 0,6 0.2 0.9 1.B 3.1 6 years 0.7 0.2 0.9 1.B 3.1 7 years 0.7 0.3 0.9 1.8 3.1 8 years 0.7 0.3 0.9 1.8 3.1 9 years 0.8 0.3 0.9 1.8 3.1 10 years 0.8 0.4 0.9 1.8 3.1 3.1 Case 1 Babes-N-Toyland 793 ESTIONS 1. Using the data provided in Table 1. construct the yield curves for August 1991, August 1992. and November 1992 2. Evaluate the change in the shape of the yield curve between (2) August 1991 and August 1992, and (b) August 1992 and November 1992 using expectations theory and market segmentation theory 3. Calculate the one-year forward rates of interest implied by the November 1992 yield curve over the period 1993-2002 4. Using the one-year forward rates obtained in Question 3, calculate the expected annual inflation rate in each of the next ten years, and use this information to obtain the average rate of price ap preciation expected over the 1993-2002 period. In your calculations, assume a strict expecy tions theory approach to nominal interest rate construction, where kok + Expected inflation premium 5. Examine the information provided in Table 2. Do these data lead you to believe that the annual inflation rates you calculated in Question 4 might be incorrect? Why or why not? 6. Using the data provided in Tables 1 and 2 prepare a revised estimate of (a) the one-year for ward interest rates implied by the November 1992 yield curve over the 1993-2002 period; and (b) the expected annual inflation rate in cach of these years. 7. How would the yield curve for (a) an AAA-rated firm, (b) a B-rated firm, and (c) a Crated firm, differ from the Treasury security yield curve you constructed in Question 17 Plot the individual yield curves for each of these risky securities to demonstrate your answer. 8. In Question I you constructed a serics of yield curves using Treasury security yields, while in Question 7 you constructed yield curves using the term structure of interest rates for various classes of risky debt. In most cases, financial analysts prefer the former approach to yield curve construction. Why is it better to construct the yield curve using the term structure of returns drawn from Treasury securities rather than risky corporate bonds? 9. Can you use the information provided in the case to estimate Babes-N-Toyland's bond rating? If so, identify this rating, and explain how you obtained it 10. If Babes-N-Toyland issues 10-year corporate bonds to fand its expansion plans and these bonds are priced to sell at par in the market, what is the semi-annual coupon payment that the firm must offer its bondholders? 11. Based on your answers to Questions 1 through 10. is now a good time for Babos-N-Toyland to issue a large quantity of long-term debt securities? Why or why not