[Solution]Questions on Bonds and Convertible bonds

Q3. (a) Sao plc is considering a new five-year project. The project will require an immediate investment of £16m, with a residual value of £7m.…

Q3. (a) Sao plc is considering a new five-year project. The project will require an immediate investment of £16m, with a residual value of £7m. Net income from the project, before depreciation and tax, is as per the following table:

The company faces a corporation tax rate of 20%; and would depreciate the £16m investment on a straight-line basis over the life of the project down to its residual value. It may be assumed that depreciation is an allowable expense against taxable profits. Tax is payable one year in arrears (so, e.g.,tax in respect of year 1 is paid in year 2).

The company intends to fund the project from part of the proceeds of a bond issue as follows: £25m nominal value 10-year 7.5% bonds with coupon payable annually and to be redeemed for 10% more than nominal value. The appropriate discount rate for appraisal of the project is 8.5% p.a.; and, in current market conditions, a yield to maturity of 11% p.a. will be expected from the bonds.

If the project and bond issue are undertaken, discuss the possible impacts on the value of Sao plc.[14 marks]

(b) Use duration and convexity measures together to estimate the change in value of the project and the bond if interest rates in general increase by 1.5%; and check the accuracy of your estimations.[12 marks]

(c) Discuss why Sao plc might consider issuing convertible bonds rather than straight bonds.[6 marks][Total: 32 marks]
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