Business Finance

Executive Summary of Business Finance

The report provides a summary of the bonds and its feature. Simpsons Company has planned to issue bonds for the purchase of new machinery. The report defined the best and effective coupon rates that are to be fixed by the company. The company is paying interest rates that are more than the prevailing market rates. This will attract the investors for the company. Also, the company can issue the bonds at the par value. Then the report studies various features that are related to the bonds and the agency problems that may arise. Interest rates should be such that they remove the problem between both the investor and issuer. In this manner, a report is prepared accordingly by considering the coupon rates and yield to maturity of the bonds.

Introduction to Business Finance

Bonds refer to the fixed income instruments. These are the type of loan that is taken by the companies from the investors (Dennison 2018). Bond shows an indebtedness of the issuer towards the holders. Commonly bonds are issued by the municipalities and corporates. It is a form of debt security and reflects that the issuer is under the obligation of paying a certain amount that is referred to as interest or coupon payments that are made yearly, quarterly or monthly (Murphy 2016). The principal is returned on the date of maturity of the bond. The report aims at a company i.e. Simpsons Ltd which is a public company. The company has plans to buy a new plant. The amount required for buying that plant is $5 million. The company has decided to fund the plant through an issue of 12 years bond. The coupon payments that will be made by the company will be yearly. Coupon rate refers to the yields that the issuer will pay according to the par value of the bonds. Coupon payments are decided as per the market risk and also the interest rate that is running in the market. The report also studies the difference between the YTM and coupon rate and features of the bonds have been studied.

Coupon Rates

Coupon rates refer to the yield that is paid by fixed-income security. It is the annual coupon payment that is paid by the issuer on the face value of a bond or as per the par value of a bond (Hilscher, Jarrow and van 2019). It is the payment that is made in the form of interest as a security to the investor. Coupon rates are the measures that affect the yield. The coupon rates on the bonds are fixed throughout their life.

Appropriate Rates of Coupon for The Bonds

Coupon rates are to be set at an appropriate level. These are the returns that an investor gets. If, the rates are lower than the investor will not get the accurate returns. Coupon rates are set appropriately concerning the rates that are prevailing in the market (Bhaumik 2016). The market rates are checked according to the times the bonds are being issued. Market rates are subjective to changes. There are various factors like demand, supply, and also the inflation rates that affect the rates prevailing in the market. Changes in the rates of the market also brings changes in the value of bonds.

If the coupon rates are not according to the prevailing market rates than investors would not like to invest in the bonds. This will lead to less investment in the bonds. The reason for the above is that an investor can get better returns by investing in the market than investing in the bonds.

For setting an appropriate coupon rate a margin of safety should also be included in the bonds. There are chances that the rate of interest in the market goes up, and bonds are issued for a longer duration of time (Diaz, Jareno, and Navarro 2019). This increases the chances. So, to minimize that risk, there is a margin of safety that is attached to the coupon rates of bond. This will save the loss of investors, if the market prices go high.

Also, there are chances that the rates that are prevailing in the market goes down. If, the market rates go down then, the value of the bonds will increase in the market, and investors would like to buy more of the bonds. At, this time company can issue bonds at a premium so that it covers the loss that it is paying extra to the bondholders.

Thus, the appropriate coupon rate should be set in a manner that they are above the market price that is prevailing. The margin between the coupon rate and market rate is the margin of safety. Hence, the appropriate coupon rates should include the market rates and the margin of safety.

Coupon Rate versus Yield to Maturity on Bonds

Coupon Rate

Yield to maturity

The coupon rate is the amount that is received by the investor in bonds on an annual, quarterly or monthly basis. The interest rates on the bonds are set in the beginning and they remain constant throughout the life of the bonds. The coupon rates are declared on the face value of the bonds. The interest is calculated according to the face value.

The value of the coupon rate and YTM will be the same if the bonds are purchased at the par value. The value of YTM will be higher if the bonds are issued at a discount and lesser if the issue price of bonds is more than its face value.

The percentage return that is received on the bonds is known as Yield to maturity. It is the total return that is anticipated on the bond if it is being held till the time of maturity. It is considered as a long term yield on bonds but the yield is expressed in the annual rate format (Leland 2019). It can also be termed as an internal rate of return for the investment on bonds.

Yield to maturity includes all the coupon payments that are remaining. The yield varies according to the value in the market and it is inversely proportional concerning the prices that are prevailing in the market.

Coupon Rates

Scenario 1. Issued at Par value

Assumption:

The face value for each bond = $1000

 

(At the time of issue of bonds interest or coupon payment and yield are at par).

Par value

1000

Interest rate

5%

Payment

Annually

Annual payment

50

Coupon rate

Annual payment/ par value*100

 

5.00%

Scenario 2. Issued at 95% par value

Assumption:

The face value for each bond = $1000

Par value

950

Interest rate

5%

Payment

Annually

Annual payment

50

Coupon rate

Annual payment/ par value*100

 

5.26%

The rates for the bonds that are prevailing in Australia for 10 to 12 years of bond stands at 3 to 4%. While the coupon will be paying an annual interest of 5% on the bonds. This is better than all the bonds that are prevailing in the country.

The company should issue the bonds at par value as if the company issues the bonds at a discount than it will have to pay more than it will receive. The rates are better so the investor will be attracted to it. It is more effective for the company to issue the bonds at 100% par value than at 95%. Investors look for better investment opportunities and higher interest rates. The company is providing the window and the gap is 2%, thus it will become easier to attract the investors.

Different Features of The Bond

The various features of bonds include the following:

  • Market price: Bond prices usually get affected by various factors of the market. Interest rates are one such factor that affects the prices of the bonds. If the interest rates are lower than the coupon rate provide by the bonds, then the value or the prices of bonds will rise and vice versa (Horvath, De Jong, and Werker 2017). The other factors include currency, interest payment timings, and also the availability of options for redemptions of the bond.

The agency problem arises when there is a conflict between the agent and the principal. Agency theory tries to resolve that issue. If the bond prices are higher in the market, the investor would like to sell and invest in the bonds of lower prices. This leads to certain agency problems between the issuer and investor. To resolve the problem through agency theory interest rates should be as such that both the investor and issuer are benefitted accordingly and purpose in solved for both of them.

  • Value at par for bonds: It is the amount that the bondholder receives when the bond reaches maturity (Gargano, pettenuzzo, and Timmermann 2019). Bond is sold at three prices that are at par, premium or discount.

When the bond is sold at par, the face value and the redemption value of the bond is the same. The price at which the bond is purchased is given back to the investor.

When the bonds are issued at a discount, then the face value is more while the selling price of the bonds is reduced. This creates an agency problem between the buyer and the issuer. The issuer has to pay more than it is receiving. It leads to conflict. To resolve this through agency theory, interest rates are reduced in a manner that the issuer's loss is covered and still the profits of the investors are maintained.

In the case of premium, bonds are issued at prices higher than the face value. In this situation, the investor has to pay more. And investor only pays more if the bonds are providing more interest rates that are prevailing in the market. This helps in resolving the agency conflicts with regards to the par value feature of the bonds.

  • Interest rates/ coupon rates: The payments or the interest that is paid to the investor for investing in the bonds is an important feature. These coupon rates or interest rates depict the interest that an investor will take into buying or investing in a particular bond. Interest rates creates a conflict between the issuer and investor. Investors like to have high returns, so they expect interest rates to be higher. While the issuer likes to keep the rates according to the running market rates, as this will help them in paying lesser money to the investors, in comparison when the rates will be higher. Since the investor takes a risk and invests in a longer duration of bonds a safety margin for varied conditions is provided and the rates are set according to that.
  • Maturity date: It is the time when the payment and interest are made in full to the investor. If the date of maturity is longer then the risk attached to the bonds also rises. As, when the period is long market factor changes, interest rates go down and at times go up. Also, there are chances of non-payment of bonds by the issuer. This is managed through adding a pillow of safety with regards to the coupon rates of the bonds.

These are certain features that are attached to the bonds.

Conclusion on Business Finance

Simpsons Ltd. Is planning to issue bonds for 12 years. To issue bonds the basic feature that is to be considered is the coupon rates. These rates should be above the market rates as they include a margin of safety. The coupon rate on which the company should issue the bonds will be at 5%. These rates are on the par value of the bond. The company's interest rates are higher than the other prevailing bonds in the market so the company should issue bonds at par value. Bonds also have various features like coupon rates, maturity dates, etc. and various agency problems occur in applying these features that can be resolved by selecting the best rate of interest for the bonds.

References for Business Finance

Bhaumik, P.K. 2016. An appropriate risk addendum for risky projects. Managerial Finance. [Online]. Available at: https://www.emerald.com/insight/content/doi/10.1108/MF-06-2015-0176/full/html Accessed on:[30 April 2020].

Dennison, T. 2018. Bonds, Fixed Income, and Money Markets. In Invest Outside the Box (pp. 9-53).

Díaz, A., Jareño, F., and Navarro, E. 2019. Zero-coupon interest rates: Evaluating three alternative datasets. Economic research-Ekonomska istraživanja32(1), pp.3987-4014.

Gargano, A., Pettenuzzo, D., and Timmermann, A. 2019. Bond return predictability: Economic value and links to the macroeconomy. Management Science65(2), pp.508-540.

Hilscher, J., Jarrow, R.A. and van Deventer, D.R. 2019. The Valuation of Corporate Coupon Bonds. Available at SSRN 3277092.

Horváth, F., De Jong, F. and Werker, B.J. 2017. Robust Pricing of Fixed Income Securities. Available at SSRN 2760048.

Leland, H. 2019. Bond prices, yield spreads, and optimal capital structure with default risk. Finance40(3), pp.45-75.

Murphy, R. 2016. Corporate bonds. Equity30(11), p.9.

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Business Finance Assignment Help

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