ACCT1060 Management Accounting and Business

7.5% Graded Group Assessment Week - 6

Student 1 Student 2 Student 3 Student 4

ID Number

Tutor’s Name

Day + Time of
your tutorial
class
Your name

ALLOWABLE MATERIALS AND INSTRUCTIONS TO GROUPS

1. This is a limited open book assessment. Please refer to the instruction below.
(Students can use their lecture notes and only laptop can be used to get access to given company
data)
2. Spend 45 minutes + 5 minutes reading time

3. Please form four-member group to do the assessment (expects equal contribution from
each member of a group)
4. Non-programmable calculators are permitted.
Programmable calculators are not permitted at any time.

5. Except your laptop, all electronic devices, mobile phones and smart gadgets must be
switched off and placed INSIDE your bag. You are in breach of exam conditions if it is on
your person (i.e pocket).

6. Attempt ALL questions and ALL parts of questions

7. NOTE: Assessment cannot be retained by the student and must not be removed from
the assessment venue.

ACCT1060 MAB Week-6 In-class Assessment Version -1 1

QUESTION ONE – BONDS CHARACTERISTICS

a. Discuss as for why companies decide to issue bonds as a source of finance?

There will be very different answers from the students for this question, therefore, I
will allow you to use your judgment on students’ answers. However, see the
suggested guideline below:

Corporations issue bonds for several reasons:

1. Provides corporations with a way to raise capital without diluting the current
shareholders' equity.
2. With bonds, corporations can often borrow at a lower interest rate than the
rate available in banks. By issuing bonds directly to the investors,
corporations can eliminate the banks as "middlemen" in the transactions.
Without the intermediaries, the borrowing process becomes more efficient
and less expensive.
3. By issuing bonds, corporations can often borrow money for a fixed rate for a
longer term than it could at a bank. Most banks will not make fixed rate
loans for longer than five years because they fear losing money if their cost
of funds (raised by selling CDs, savings accounts, and the like) rises to a
higher rate than long-term loans. Most companies want to borrow money for
long terms and so elect to issue bonds.
4. The bond market offers a very efficient way to borrow capital. By issuing
bonds, the borrower is spared the task of undergoing numerous separate
negotiations and transactions in order to raise the capital it needs.

Instead, when corporation issues bond, creates one master loan agreement and
offers investors a chance to participate in the loan. The company offers the
identical deal to all investors regardless of whether the individuals interested in
buying just one bond each or corporations buying 1000 bonds. The master loan
agreement between the corporation and the investors is called a bond indenture.
The indenture contains information that you would expect in any loan agreement
such as:

• The amount of money the company is borrowing.

• The interest rate the company will pay.
• The collateral for the loan (if any).
• When the company will make its interest payments.
• Whether the company will pay off the loan, that is, when the bonds will
mature.
• Whether the company and/or the investors will have the choice of
shortening the bond's original maturity.

ACCT1060 MAB Week-6 In-class Assessment Version -1 2

 b. Explain why bond prices have an inverse relationship with interest rate movements?

Suggested Answer:

Since the coupon rate of a bond is fixed until maturity, the price of a bond will vary according
to interest rate movements in the market. If the coupon rate is the same as the market interest
rate, then the bond will sell for its par value (i.e. a ‘par bond’).

However, if the coupon rate is greater than the market interest rate, then there will be increased
demand for the bond which causes an increase in the market price of the bond, resulting in the
bond selling for a premium (i.e. a ‘premium bond’).

Conversely, if the coupon rate is less than the market interest rate, then there will be decreased
demand for the bond which causes a decrease in the market price of the bond, resulting in the
bond selling for a discount (i.e. a ‘discount bond’).

In this way, bond prices are said to have an inverse relationship with interest rate movements,
with bonds prices increasing when market interest rates decline and bond prices decreasing
when market interest rates rise.

QUESTION TWO – BONDS VALUATION

Sonia bought a bond when it was issued by ABC Ltd 14 years ago. The bond which has a $
1000 face value and a coupon rate equal to 10 per cent. Matures in 6 years. Interest is paid
every six months; the next interest payment is scheduled for six months from today. If the yield
on similar risk investments is 14 per cent, what is the current market value of the bond?

ACCT1060 MAB Week-6 In-class Assessment Version -1 3

QUESTION THREE - BONDS VALUATION (Woolworths Group Ltd)

Key data regarding Woolworths’ Bond valuation have been provided below:

The required return on the Wool's Bond (rd) 4%

Number of years (periods) to maturity (n) 5
Par value (face value) in dollars (M) $1,000
Coupon rate 6%

a. Calculate the Bond’s value, if interest is paid annually and justify your answer.

B0 = I * (PVIFA rd, n) + M * (PVIF rd, n)

Ø M=$1,000
Ø Cr = 6%
Ø rd = 4%
Ø n=5
Ø I = coupon interest rate X per value : 0.06 X $1,000 = $60
Ø PVIFA 4%, 5 = 4.452
Ø PVIF 4%, 5 = 0.822

B0 = $60 * 4.452 + $1,000 * 0.822 = $1,089.12

Therefore, the bond has a value of approximately $1,089 and is selling at a premium of
$89 (1,089-1,000), because of r < C

b. Repeat the calculations in question (b) assuming that interest is paid semi-annually
and justify your obtained results.

!
B0 = * (PVIFA rd/2, 2n) + M * (PVIF rd/2, 2n)
"
Ø M=$1,000
As interest rate (C) is paid semi-annual:
Ø Cr/2 = (6/2) % = 3%
Ø rd/2 = (4/2) % = 2%
Ø 2n = 5 X 2 = 10

ACCT1060 MAB Week-6 In-class Assessment Version -1 4

 !
Ø "
= I/2 * per value : 0.03 X $1,000 = $30
Ø PVIFA 2%, 10 = 8.983
Ø PVIF 2%, 10 = 0.820

B0 = $30 * 8.983 + $1,000 * 0.820 = $1,089.49

Therefore, the bond has a value of approximately $1,089 and would sell for a premium
of about $89 (1,089-1,000), because the required return is less than the coupon interest
rate.
c. Compare and discuss differences between the bond values for each required return
calculated in question (b) and (c) under annual versus semi-annual payment
assumptions.
Comparing above results in question c ($1,089.49) with the $1,089.12 value found
earlier for annual compounding (see question c), we can see that the bond’s value is
(slightly) higher when semi-annual interest is paid. This will always occur when the
bond sells at a premium. For bonds selling at a discount, the opposite will occur: the
value with semi-annual interest will be less than with annual interest.

d. What factors determine a bond’s rating? Why is the rating important to the
Woolworth’s CFO?
Ratings involve a judgment about the future risk potential of the bond. Although they
deal with expectations, several historical factors seem to play a significant role in their
determination. Bond ratings are favourably affected by (1) a greater reliance on equity,
and not debt, in financing the firm, (2) profitable operations, (3) a low variability in
past earnings, (4) large firm size, and (5) little use of subordinated debt. In turn, the
rating a bond receives affects the rate of return demanded on the bond by the investors.
The poorer the bond rating, the higher the rate of return demanded in the capital
markets.
For the financial manager, bond ratings are extremely important. They provide an
indicator of default risk that in turn affects the rate of return that must be paid on
borrowed funds.

ACCT1060 MAB Week-6 In-class Assessment Version -1 5

1. Bond ratings

Assume that Woolworths recently acquired an alcohol beverage company that was in financial
distress. Because of the acquisition, Mood’s downgraded this Bond from Baa2 to Ba2 to
reflect an increase in risks of the Woolworths Group Ltd. What impact will this have on the
bond value? Explain. NOTE THAT CALCULATIONS ARE NOTE REQUIRED HERE.

Financial managers usually are concerned with ratings of the bond issue, because these ratings
affect saleability and cost. There exist an inverse relationship between the quality of a bond
and the rate of return that must be provided to bondholders. This reflects the lender’s risk-
return trade-off.

Therefore, the lower a bond’s rating, the higher the perceived default risk, the higher the interest
rate required by investors, which lead potentially to a reduction in Woolworths’ bond value.

Formulas:

1. Basic bond valuation for annual interest rate

Bo = I * (PVIFA rd, n) + M * (PVIF rd, n)

ü Where Bo = value of the bond value = (Vd)

ü M = Maturity Value (par value)
ü C = coupon interest rate
ü I represent an interest paid in dollars (coupon payment in dollars):
ü I = coupon interest rate (C ) * per value (M);
ü PVIFA = present value interest factors for one-dollar annuity discounted at r for n
periods. Corresponding values are obtained from the financial table.
ü rd = the average rate of return investors requires to invest in the bond.
ü n = number of years (periods)
ü PVIF = present value interest factors for one dollar discounted at r for n periods.

2. Bond valuation for interest paid semi-annual

!
Bo = "* (PVIFA rd/2, 2n) + M * (PVIF rd/2, 2n)

ACCT1060 MAB Week-6 In-class Assessment Version -1 6