finance case study
Atlantic Airlines issued $100 actor in bonds in 2015. Because of the firm’s low acclaim appraisement (B3), the bonds were advised to be clutter bonds. At the time of issue, the 20 year bonds were advantageous a crop of 12 percent.
Investor Tom Phillips anticipation the crop on the bonds was decidedly adorable and alleged his broker, Roger Brown, to ask for added advice on the debt issue. Tom currently captivated Treasury bonds advantageous four percent absorption and accumulated bonds acquiescent six percent. He wondered why the debt affair of Atlantic Airlines was advantageous alert that of his alternative accumulated bonds and eight percent added than Treasury securities.
His broker, Roger Brown had been a banking adviser with Merrill Lynch for 10 years and was frequently asked such questions about yield. He explained to Tom that the bonds were not advised advance brand because of the industry they were in. Bonds of airlines are advised to be inherently chancy because of acknowledgment to airy activity prices and the aerial debt akin that abounding airlines carry. He added explained that they frequently were labeled “junk bonds” because their appraisement did not abatement into the four accomplished categories of ratings by the band appraisement agencies of Moody’s and Standard and Poor’s.
Questions from Tom Phillips
This account did not avert Tom from assuming connected interest. In fact, he could hardly delay to get his easily on the 12 percent acquiescent securities. But first, he asked Roger, “What is the accurate accident and is it account taking?”
Roger explained there was a college accident of absence on clutter bonds. It sometimes ran as aerial as 2-3 percent during astringent bread-and-butter downturns (compared to .5 percent for added accepted issues). Roger additionally adumbrated that although the crop at the time of affair appeared high, it could go
considerably college should altitude aggravate in the airline industry.
This would booty abode if the amount of oil confused acutely advancement or bodies began aerial beneath due to a abatement in the economy. Roger explained that if the crop (required return) on bonds of this attributes went up, the amount of the bonds would go bottomward and could potentially clean out the aerial absorption acquittal advantage.
1. If the crop in the bazaar for bonds of this attributes were to go up to 15 percent due to poor bread-and-butter conditions, what would the new amount of the bonds be? They accept an antecedent par amount of $1,000. Assume two years accept anesthetized and there are 18 years actual on the activity of the bonds. Use anniversary analysis.
2. Compare the abatement in amount to the eight percent antecedent absorption advantage over Treasury bonds (12 percent against four percent) for this two year captivation period. Base your assay on a $1,000 bond. Disregarding tax considerations, would Tom appear out advanced or abaft in affairs the aerial crop bonds?
3. Recompute the amount of the bonds if absorption ante went up by alone one percent to 13 percent with 18 years remaining. Does the 8 percent absorption amount advantage over the two year captivation aeon awning the accident in value?
4. Now accept that bread-and-butter altitude advance and the crop on agnate balance goes bottomward by 2 or 3 percent over the two years. How does Tom appear out? Merely altercate the answer. No adding is necessary.
5. If Tom holds the bonds to ability (and there is no default), does the change in the appropriate crop in the bazaar over the activity of the band accept any absolute aftereffect on the investment?
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