Inv3702 Assignment 2, S2 2024

STUDENT NUMBER: 53768655
STUDENT NAMES: MUTALE DALIA MAFWELA

MODULE: INV 3702
ASSIGNMENT 2 ANSWERS
Question 1
The price of Bond E, a 3-year coupon bond (as a percent of the par value) is:
N = 3; I/YR = 2.711; PMT = 6; FV = 100; PV=?
Compute PV = –109.36
The no-arbitrage value price of the 3-year coupon bond based on spot rates is:
6/1.02350 +6/(1.02500)^2 +106/(1.02725)^3= 109.36
The 3-year coupon bond's price equals its no-arbitrage value, therefore the bond
is fairly
valued.
Question 2
Bond A has a higher yield than its peers, making it underpriced. The trader
should buy this bond because it will increase in price, as the trader expects when
its bond yield to returns is equal to the yield to maturity of the peer group.
Question 3
Ms Koko’s decision to allocate the funds to Bond A is correct. According to the
pure expectations theory, an inverted yield curve (downward-sloping term
structure of interest rates) indicates that future short-term interest rates are
expected to decline due to declining inflation rates. The purchaser of a callable
bond must be reimbursed with a higher yield. As rates fall, the option becomes
more valuable, and the price of Bond B will not appreciate as rapidly as the
noncallable Bond A. The negative convexity of the callable bond will limit its
price appreciation potential.
Question 4
The recommended analyst adjustments are to add the present value of operating
lease obligations and net pension liabilities to total debt before calculating
leverage ratios. Total capital should also be added both including and excluding
goodwill. The following financial information includes these adjustments
Company Y
Earnings before interest and tax = 550,000
Funds from operations =300,000
Interest expense =4, 000
Total debt plus Present value of operating leases plus Net pension liability
(1,000,000 + 0+300,000) =1,300,000
Total capital (including goodwill) = 4,000,000
Total capital (excluding goodwill) (4,000,000 – 500,000) =3,500,000
Company Z
Earnings before interest and tax = 2,250,000
Funds from operations=850,000
Interest expense=160,000
(2,500,000 +0+200,000) = 2,700,000
Total capital (including goodwill) (6,500,000) =6,500,000
Industry average
Earnings before interest and tax = 1,400,000
Funds from operations=600,000
Interest expense=100,000
(2,400,000 +0+200,000) = 2,600,000
Total capital (including goodwill) =6,000,000
Total capital (excluding goodwill) (6,000,000-200,000) =5,800,000
The following ratio calculations are based on the adjusted data above:
EBIT/interest
Company Y: 550 000 / 40 000 = 13.8x
Company Z: 2 250 000 / 160 000 = 14.1x
Industry average: 1 400 000 / 100 000 = 14.0x
From the calculations it can be seen that both Company Y and Company Z have
interest coverage in line with their industry average
FFO / total debt:
Company Y: 300 000 / 1 300 000 = 23.1%
Company Z: 850 000 / 2 700 000 = 31.5%
Industry average: 600 000 / 2 600 000 = 23.1%
From the calculations it can be seen that Company Z’s funds from operations
relative to its debt level are greater than the industry average, while Company Y
is in line with the industry average.
Total debt / total capital (including goodwill):
Company Y: 1 300 000 / 4 000 000 = 32.5%
Company Z: 2 700 000 / 6 500 000 = 41.5%
Industry average: 2 600 000 / 6 000 000 = 43.3%
Total debt / total capital (excluding goodwill):
Company Y: 1 300 000 / 3 500 000 = 37.1%
Company Z: 2 700 000 / 6 500 000 = 41.5%
Industry average: 2 600 000 / 5 800 000 = 44.8%
From the calculations it can be seen that Company Y is less leveraged than
Company Z and the industry average, especially after adjusting for goodwill.
Based on the calculated ratios Company Y appears to be more creditworthy than
Company Z.
Question 5
The statement is incorrect because floating-rate securities are subject to interest
rate risk and this is also because their coupon rates are not reset continuously.
The longer the time until the security’s next reset date, the greater its potential
price changes away from par value (to a discount or premium).
Question 6
The binomial interest rate tree
R93.01
R3 R103
R92.21
10.7383%
R3
R96.01
5.7883%
R94.49 R3 R103
3.0000% 7.1981%
R96.43 R93.26
R3 R3 R103
3.8800% 4.8250%
Year 0 Year 1 Year 2 Year 3
103
V 2,UU = =R93.01
1.107383
103
V 2 ,UL= =R96.08
1.071981
103
V 2 ,¿= =R98.26
1.048250
1 93.01+3 96.08+3
V 1 ,U = + ( + ) =R92.21
2 1.05883 1.057883
1 96.08+3 98.26+3
V 1 ,L = + ( + ) = R96.43
2 1.038800 1.038800
1 92.21+3 96.43+3
V 0= + ( + 1.03 ) = R94.49
2 1.03

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STUDENT NUMBER: 53768655

STUDENT NAMES: MUTALE DALIA MAFWELA

Year 0 Year 1 Year 2 Year 3

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