Question 2 (30 marks)

PQR Co manufactures glass bottles for the drinks industry. It has been in the business for 15 years. In the past the company has been relying on bank loan for financing its business. In the near future, the company is expected to grow by 7 to 8 percent a year. The CEO of the company is considering to issue corporate bonds to finance its future expansions. He has asked you to help him in the issue and gathered the following information:

(1) A share of 5 year 4.25% coupon Treasury note is sold at $1033.86.

(2) A share of 10 year 4.25% coupon Treasury note is sold at $1020.08.

Both of the T-notes have $1000 par value.

The CEO determines to issue bonds with par value $1000 each, an annual coupon rate of 5% and maturity of10 years from today. It is also estimated that the liquidity and default risk premium is 2% for PQR's bond.

Required:

a.The CEO asks you about the yield curve and its significance to financing. Calculate the yields on the 5-year and 10-year T-notes and explain to the CEO the shape of the yield curve and its significance to financing.(12 marks)

b.What is the price for PQR's bond? If the CEO wants to raise $20 million, how many shares of the bonds has to be issued?(6 marks)

c.After 2 years, suppose the credit rating of PQR deteriorates such that the interest rate required by investors on PQR's bond increases to 7%. What will be the price of PQR's bond?(4 marks)

d.Briefly explain the factors that will influence the rate of interest charged on a new issue of bonds.(8 marks)