QUESTION 1 CASE A A. Lakamuun is an individual with low risk tolerance who has just inherited $100,000 from her father Osei-Anim Reindolph. She has no immediate needs for the funds but would like to supplement her current income. Thus, Laka as she is affectionately called is considering investing these funds in debt instruments, since the interest and repayment of principal are legal obligations of the issuer. While she realizes that the borrower could default on the payments, she believes this is unlikely, especially if she limits her choices to triple- or double-A-rated bonds. Laka does realize that she could earn more interest by purchasing lower-rated bonds hut is not certain that she is capable of bearing the risk. Besides risk and expected return, "Laka decides that tax considerations must also play a role in this investment decision. She is currently in the 28 percent federal income tax bracket and pays state income tax of 5 percent. She believes that her job is relatively secure and that her salary will increase over time but does not expect it to rise sufficiently so that her income tax brackets will be significantly increased. Laka quickly learned that there are many bonds among which to choose. For example, the PHONE Company has four double-A bonds outstanding. Their annual interest payments (or coupon rate), term to maturity, price, and yield to maturity are: Bond Interest per $1,000 Bond Coupon % A 50 5 B 100 10 C 100 10 D 80 8 Term Price Yield to Maturity % 1 year $981 7.0% 1,035 9.1 5 years 10 years 1,000 10.0 20 years 742 11.3 Currently the interest rate of long-term debt ranges from 9 to 11.5 percent, but Laka expects that this rate will fall, as inflation is declining. In addition, the level of unemployment is increasing, so she anticipates that the Federal Reserve will take actions to stimulate the economy through reductions in the rate of interest. She believes that interest rates could fall to 8 percent within a year. Of course, Bond ABCD she also realizes that this decline may not occur- or even if it does, that interest rates could rise again after the initial decline. Laka decided to analyze the four PHONE Company bonds to determine which may be the best investment under various assumptions concerning future interest rate behavior. To do this she sought your help as an investment analyst in answering the following questions: i. 5. What would be the expected price of each bond one year from now if interest rates were 8 percent? B. What would be the expected price two years from now if interest rates initially fall but subsequently rise to 12 percent at the end of the second year? ii. If interest rates were expected to fall and not rise back to 12 percent, which alternative is best? iii. If interest rates were expected to decline initially and then rise, which alternative should be selected? iv. If bond A were selected, what would happen after a year elapses? What decision must then be made? The answers to these questions emphasize to Laka the importance of expected future interest rates on the selection of a bond. Since she firmly believes that interest rates will fall and remain below current levels for several years, she has decided to select bond D, the longest-term bond that would lock in the current high yields. However, she has also decided to consider other bonds to determine what additional returns she could earn for bearing more risk, along with the tax implications of her selections. She has noticed that the following ten-year bonds are available: Bond Interest per Price YTM Rating $1,000 ($) $ % 0 463 8 80 1,000 8 140 1,000 14 B 120 896 14 B At this point Laka is sufficiently frustrated and asks your advice. As her financial advisor and analyst, which bond(s) do you recommend? In your advice, specifically explain the tax implications (both in terms of income and capital gains) of each bond. Also consider her willingness to bear risk and the anticipated flow of income both from the bond and her job. Then construct a portfolio: that you MNOP QUESTION 1 CASE A A. Lakamuun is an individual with low risk tolerance who has just inherited $100,000 from her father Osei-Anim Reindolph. She has no immediate needs for the funds but would like to supplement her current income. Thus, Laka as she is affectionately called is considering investing these funds in debt instruments, since the interest and repayment of principal are legal obligations of the issuer. While she realizes that the borrower could default on the payments, she believes this is unlikely, especially if she limits her choices to triple- or double-A-rated bonds. Laka does realize that she could earn more interest by purchasing lower-rated bonds hut is not certain that she is capable of bearing the risk. Besides risk and expected return, "Laka decides that tax considerations must also play a role in this investment decision. She is currently in the 28 percent federal income tax bracket and pays state income tax of 5 percent. She believes that her job is relatively secure and that her salary will increase over time but does not expect it to rise sufficiently so that her income tax brackets will be significantly increased. Laka quickly learned that there are many bonds among which to choose. For example, the PHONE Company has four double-A bonds outstanding. Their annual interest payments (or coupon rate), term to maturity, price, and yield to maturity are: Bond Interest per $1,000 Bond Coupon % A 50 5 B 100 10 C 100 10 D 80 8 Term Price Yield to Maturity % 1 year $981 7.0% 1,035 9.1 5 years 10 years 1,000 10.0 20 years 742 11.3 Currently the interest rate of long-term debt ranges from 9 to 11.5 percent, but Laka expects that this rate will fall, as inflation is declining. In addition, the level of unemployment is increasing, so she anticipates that the Federal Reserve will take actions to stimulate the economy through reductions in the rate of interest. She believes that interest rates could fall to 8 percent within a year. Of course, Bond ABCD she also realizes that this decline may not occur- or even if it does, that interest rates could rise again after the initial decline. Laka decided to analyze the four PHONE Company bonds to determine which may be the best investment under various assumptions concerning future interest rate behavior. To do this she sought your help as an investment analyst in answering the following questions: i. 5. What would be the expected price of each bond one year from now if interest rates were 8 percent? B. What would be the expected price two years from now if interest rates initially fall but subsequently rise to 12 percent at the end of the second year? ii. If interest rates were expected to fall and not rise back to 12 percent, which alternative is best? iii. If interest rates were expected to decline initially and then rise, which alternative should be selected? iv. If bond A were selected, what would happen after a year elapses? What decision must then be made? The answers to these questions emphasize to Laka the importance of expected future interest rates on the selection of a bond. Since she firmly believes that interest rates will fall and remain below current levels for several years, she has decided to select bond D, the longest-term bond that would lock in the current high yields. However, she has also decided to consider other bonds to determine what additional returns she could earn for bearing more risk, along with the tax implications of her selections. She has noticed that the following ten-year bonds are available: Bond Interest per Price YTM Rating $1,000 ($) $ % 0 463 8 80 1,000 8 140 1,000 14 B 120 896 14 B At this point Laka is sufficiently frustrated and asks your advice. As her financial advisor and analyst, which bond(s) do you recommend? In your advice, specifically explain the tax implications (both in terms of income and capital gains) of each bond. Also consider her willingness to bear risk and the anticipated flow of income both from the bond and her job. Then construct a portfolio: that you MNOP