Question One

Sally Vallely is a financial analyst with an investment company that specializes in fixed-income securities. The firm's portfolio managers have shown an interest in the bonds issued by ExperienceYou, a rapidly growing firm that specializes in catering to experiences for baby boomers. ExperienceYou has several bonds outstanding. Each bond matures in 20 years and is sold in units of $1,000. The current price of each bond is $1,000, and the price of the stock is $8.50. The specific features associated with each bond are as follows:

A4 percent convertible debenture

conversion price$10 (bond may be converted at any time)

call price $1,000 + 1 yea r s interest

sinking fund retires 10 percent of the bond each year starting after 10 years have elapsed.

B8 percent subordinated debenture

call price $1,000 + 1 years interest

no sinking fund

C6 percent mortgage bond

call price $1,000 + 1 year's interest

sinking fund retires 5 percent of the issue each year

D7 percent callable debenture

callable after 10 years at par

sinking fund retires 5 percent of the issue each year

E6 percent put bond

put may be exercised after 10 years

sinking fund retires 10 percent of the bond each year starting after 10 years have elapsed.

Currently, the company is earning $0.85 per share but does not pay a cash dividend. Times-interestearned is 5.4, and Vallely expects the stock to grow at least 10 percent annually, which should match the comparable stock indexes.

Previous meetings with portfolio managers have raised several questions concerning the risk associated with the company's bonds, especially their price volatility and potential for default. To be well prepared Vallely needs answers to several questions that you have been tasked with answering. They are:

1.Which bonds should Vallely expect to have the highest and the lowest credit ratings? What does the times-interest-earned number indicate about the probability of any of the bonds defaulting in the immediate future? Does the times-interestearned of 5.4 apply to each bond or all of them?

2.Each bond has 20 years to maturity and is selling for its par value. What explains the differences in yields? Are these yields current yields or anticipated yields?

3.Since duration is one measure of price volatility, what is the duration of each bond? What assumptions must be made to answer this question? Why may duration have little applicability to some of the bonds, and which ones?

4.If, after one year, interest rates are essentially unchanged and the price of the stock remains in the doldrums at $8.50, what should be the price of each bond?

5.If, after five years have elapsed and interest rates have risen 2 percentage points (200 basis points) across the board, what should be the price of each bond? What assumptions must be made to answer this question?

6.If, after 10 years have elapsed, interest rates have declined by 2 percentage points and the stock indexes have risen 9 percent annually, what should be the price of each bond? What assumptions must be made to answer this question?

7.Given prices in Question 6, what are the annualized returns on each bond? If Vallely believes that the situation in Question 6 is the most likely scenario what course of action should be recommended today?