HANDOUT SESSION 1 BOND PRICING

1. Jerome D’Souza, a successful bond dealer had come to Bangalore to deliver a lecture in a
seminar organised by a leading bank as part of its training programme to finance managers. He
has been requested to explain the basic concepts and tools useful in bond analysis. To enable
him to make the presentation Mr. D’Souza has asked you to prepare answers for the following
questions.
a. How is the value of a bond calculated?
b. What is the value of a 8-year, Rs100 par value bond with a 12 percent annual coupon,
if its required rate of return is 8 percent?
c. What is the value of the bond described in part (b) if it pays interest semi-annually,
other things being equal?
d. What is the YTM of a 5-year, Rs 100 par value bond with a 13 percent annual coupon,
if it sells for Rs 95?
e. What is the YTM of the bond described in part (d) if the approximate formula is used?
f. What is the yield to call of the bond described in part (d) if the bond can be called after
2 years at a premium of Rs5?
g. What is the realised yield to maturity of the bond described in part (d) if the
reinvestment rate applicable to the future cash flows from the bond is 15 percent?
h. The holders of the bond described in part (d) expect that the bond will pay interest as
promised, but on maturity bondholders will receive only 90 percent of par value. What
will be difference between the expected YTM and stated YTM? Use the approximate
YTM formula.
2.
Mr. Jaypal works as a middle level manager in a Public Sector Undertaking. His gross total
income is Rs.5,00,000 p.a. He wants to avail the benefit of tax rebate (@15 %) under section
88 of the Income Tax Act, by investing Rs.2,00,000 in the Tax Saving Bonds issued by the
ICICI Bank. He approaches you for your advice. Options available to Mr. Jaypal in respect of
Tax Saving Bonds are:
Issue Price Face Value Interest (%) Interest
Option Tenure
(Rs.) (Rs.) (p.a.) Payable
I 10,000 10,000 4 years 5.65 Annually
II 10,000 10,000 6 years 7.00 Annually
III 10,000 14,750 4 years 9 months DDB* DDB*
IV 10,000 17,800 6 years 9 months DDB* DDB*
* Deep Discount Bond
The marginal tax rate applicable to Mr. Jaypal is 30 percent.
You are required to
a. Determine the post-tax YTM for the four options available to Mr. Jaypal. Assume that
the interest income is tax exempt.
b. Suggest an option, if
i. The yield curve is upward sloping.
ii. The yield curve is downward sloping.
 iii. The yield curve is flat.
3. White Clouds Ltd. has made a public issue of convertible debentures of face value of Rs.100
with annual coupon of 12%. Each debenture has two parts – A and B. Part A, 50% of the face
value will be converted into one equity share after one year from the date of allotment and Part
B, the remaining 50% of the face value, will have a warrant attached to it.
The following are the options available to the investor:
(i) Exchange Part B and warrant for one equity share at the end of the 3rd year.
(ii) Retain Part B and let the warrant lapse. In that case, Part B will be redeemed at the end
of the 5th year.
The current EPS of the company is Rs.8 and its dividend payout ratio is 30%. The face value
of equity share of the company is Rs.10. The company’s earnings were growing at a rate of
20% p.a. for the past 5 years but the growth rate is expected to be 17% p.a. for the next 5 years
and stabilize at 8% p.a. thereafter. Dividend payout ratio remains constant. The required rate
of return of the equity shareholders is 14%.
Assume that at the end of 5th year the equity shares are traded at their intrinsic value.
You are required to determine whether it is desirable to invest in the debentures of the
company or not and if yes, which of the options of the bond should be chosen. Assume that
the required rate of return on convertible bond is 20% and the investor wants to sell all the
equity holdings at the end of the 5th year.