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Critical Thinking: Working capital and Characteristics of Bonds (110 Points)

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Problem 9-1: Cash conversion cycle
Problem 9-2: Short term vs. long term financing
Problem 9-3: Cost of trade credit
Problem 9-4: Bond valuation
Problem 9-5: Bond interest rates

Complete the problems in an Excel spreadsheet. Be sure to show your work to receive credit.

Module 9 Critical Thinking Assignment

Working Capital and Bonds

20X1

20X2

20X3

20X4

1,200

900

3,300

3,800

4,300

4,800

Chapter 15

Interest

10,000

Annually

10,000

Semi-annually

10,000

Semi-annually

10,000

Chapter 7

Current

Par/Face

Coupon

Years to

Value (SAR)

Rate

Maturity

10,000

Problem 9-1:	Chapter 15
Cash Conversion Cycle
Given the following information: (Amounts in 000’s SAR)
	20 X1		20X2		20X3		20X4
Sales – net	4,250	5,314	7,877	10 ,942
Cost of goods sold	2,975	3,720	5,514	7,659
Accounts receivable	618	799	1,091	1,348
Inventories	332	445	639	382
Accounts payable	425	670	704	1,555
Calculate for each year:
(1) Days sales outstanding
(2) Days of sales in inventory
(3) Days payable outstanding
(4) Cash conversion cycle
Problem 9-2:		Chapter 15
Short-term vs. long-term financing
Medina Hardware operates many hardware stores and is planning to expand to other areas.
The firm has historically reinvested earnings and borrowed using short-term borrowing.
Recent financial results are as follows: (All amounts in 000’s SAR)
Current assets					900		1,200	1,500	1,800
Fixed assets	2,400	2,600	2,800	3,000
Total assets		3,300		3,800		4,300		4,800
Current liabilities	400	800	1,600
Long-term liabilities
Owner’s equity	2,000	2,100	2,200	2,300
Total liabilities & equity
(1) Prepare new balance sheet information assuming current liabilities remain unchanged
at 400 SAR each year and the 400 SAR increase in debt is added to long-term liabilities.
(2) Calculate the current ratio and debt ratio for each year under the first scenario.
(3) Calculate the current ratio and debt ratio for each year under your revised
scenario with the additional debt added to long-term liabilities.
(4) Explain which of the two alternatives is riskier and why.
Problem 9-3: Cost of trade credit
Using a 360-day year, compute the cost of trade credit for each of the following:
(1) 1/10, net 30
(2) 2/15, net 45
(3) 3/15, net 60
Problem 9-4: Bond valuation		Chapter 7
Calculate the value of the bonds in each situation below:
	Current
	Interest		Par/Face		Coupon		Years to
Paid		Value (SAR)		Rate		Maturity	Rates
	Annually								10,000	6%	10	8%
		Semi-annually	7%
	4%		15	5%
		20	10%
Problem 9-5: Bond interest rates
What is the current annual interest rate on bonds that sell for the following?
Price (SAR)
12,842
7,850
10,000

Chapter 7

The Valuation and Characteristics of Bonds

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Learning Objectives

Distinguish between different kinds of bonds.

Explain the more popular features of bonds.

Define the term value as used for several different purposes.

Explain the factors that determine value.

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Learning Objectives
Describe the basic process for valuing assets.
Estimate the value of a bond.
Compute a bond’s expected rate of return and its current yield.
Explain three important relationships that exist in bond valuation.

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Bonds
Meaning: A bond is a type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year and repayment of principal at maturity.
Bonds are issued by Corporations, U.S. Government, State and Local Municipalities.

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Debentures
Debentures are unsecured long-term debt.
For an issuing firm, debentures provide the benefit of not tying up property as collateral.
For bondholders, debentures are more risky than secured bonds and provide a higher yield than secured bonds.

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Subordinated Debentures
There is a hierarchy of payout in case of insolvency.
The claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied.

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Mortgage Bonds
Mortgage bond is secured by a lien on real property.
Typically, the value of the real property is greater than that of the bonds issued, providing bondholders a margin of safety.

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Eurobonds
Securities (bonds) issued in a country different from the one in whose currency the bond is denominated.
For example, a bond issued by an American corporation in Japan that pays interest and principal in dollars.

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Convertible Bonds
Convertible bonds are debt securities that can be converted into a firm’s stock at a prespecified price.

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Claims on Assets and Income
Seniority in claims
In the case of insolvency, claims of debt, including bonds, are generally honored before those of common or preferred stock.

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Par Value
Par value is the face value of the bond, returned to the bondholder at maturity.
In general, corporate bonds are issued at denominations or par value of $1,000.
Prices are represented as a % of face value. Thus, a bond quoted at 104 can be bought at 104% of its par value in the market. Bonds will return the par value at maturity, regardless of the price paid at the time of purchase.

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Coupon Interest Rate
The percentage of the par value of the bond that will be paid periodically in the form of interest.
Example: A bond with a $1,000 par value
and 5% annual coupon rate will pay $50 annually (=0.05*1000) or $25 (if interest is paid semiannually).

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Zero Coupon Bonds
Zero coupon bonds have zero or very low coupon rate. Instead of paying interest, the bonds are issued at a substantial discount below the par or face value.

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Maturity
Maturity of bond refers to the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond.

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Call Provision
Call provision (if it exists on a bond) gives a corporation the option to redeem the bonds before the maturity date. For example, if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate.
Issuer must pay the bondholders a premium.
There is also a call protection period where the firm cannot call the bond for a specified period of time.

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Indenture
An indenture is the legal agreement between the firm issuing the bond and the trustee who represents the bondholders.
It provides for specific terms of the loan agreement (such as rights of bondholders and issuing firm).
Many of the terms seek to protect the status of bonds from being weakened by managerial actions or by other security holders.

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Bond Ratings
Bond ratings reflect the future risk potential of the bonds.
Three prominent bond rating agencies are Standard & Poor’s, Moody’s, and Fitch Investor Services.
Lower bond rating indicates higher probability of default. It also means that the rate of return demanded by the capital markets will be higher on such bonds.

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Factors Having a Favorable
Effect on Bond Rating
A greater reliance on equity as opposed to debt in financing the firm
Profitable operations
Low variability in past earnings
Large firm size
Little use of subordinated debt

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Junk Bonds
Junk bonds are high-risk bonds with ratings of BB or below by Moody’s and Standard & Poor’s.
Junk bonds are also referred to as high-yield bonds as they pay a high interest rate, generally 3 to 5% more than AAA-rated bonds.

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Defining Value
Book value: Value of an asset as shown on a firm’s balance sheet.
Liquidation value: The dollar sum that could be realized if an asset were sold individually and not as part of a going concern.
Market value: The observed value for the asset in the marketplace.
Intrinsic or economic value: Also called fair value—represents the present value of the asset’s expected future cash flows.

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Value and Efficient Markets
In an efficient market, the values of all securities at any instant fully reflect all available public information.
If the markets are efficient, the market value and the intrinsic value will be the same.

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What Determines Value?
Value of an asset = present value of its expected future cash flows using the investor’s required rate of return as the discount rate.
Thus value is affected by three elements:
Amount and timing of the asset’s expected future cash flows
Riskiness of the cash flows
Investor’s required rate of return for undertaking the investment

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Bond Valuation
The value of a bond (V) is a combination of:
C: Future expected cash flows in the form of interest and repayment of principal
n: The time to maturity of the loan
r: The investor’s required rate of return

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Example on Bond Valuation
Consider a bond issued by Toyota with a maturity date of 2020 and a stated coupon of 4.5%. In 2015, with 5 years left to maturity, investors owning the bonds are requiring a 2.1% rate of return.

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Toyota Bond Example
Step 1 (CF): Estimate amount and timing of the expected future cash flows:
a. Annual interest payments
0.045  $1,000 = $45 every year for five years
b. Face value to be received in 2020
$1,000

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Summary of Cash Flows
(For One Bond)
Time Bondholder Corporation
0 Price = ? Price = ?
1–5 $45 –$45
5 +1,000 –1,000

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Toyota Bond Example
Step 2 (r) Determine the investor’s required rate of return by evaluating the riskiness of the bond’s future cash flows. Remember the investors required rate of return equals the risk-free rate plus a risk premium. Here, the required rate of return (r) is given as 2.1%.

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Toyota Bond Example
Step 3: Calculate the intrinsic value of the bond.
Bond Value
= PV (Interest, received every year)
+ PV (Par, received at maturity)

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Toyota Bond Example
Using calculator:
Annual interest payments (PMT) = $45
Par value (FV) = $1,000
Years until maturity (N) = 5
Required rate of return (I) = 2.1%
Solve for PV = $1,112.80

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Bond Yields
Yield to Maturity (YTM)
YTM refers to the rate of return the investor will earn if the bond is held to maturity. YTM is also known as bondholder’s expected rate of return.
YTM = Discount rate that equates the present value of the future cash flows with the current market price of the bond.

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Bond Yields
To find YTM, we need to know:
(a) current price
(b) time left to maturity
(c) par value, and
(d) annual interest payment

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Computing YTM
What is the yield to maturity (YTM) on a 6% bond that is currently trading for $1,100 and matures in 10 years?
current price = $1,100
coupon = $60
time = 10 years
par value = $1,000

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Current Yield
Current yield is the ratio of the interest payment to the bond’s current market price.

Example: The current yield on a $1,000 par value bond with 4% coupon rate and market price of $920

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Bond Valuation: Three Important Relationships
Relationship #1
The value of a bond is inversely related to changes in the investor’s present required rate of return (the current interest rate).
As interest rates increase (decrease), the value of the bond decreases (increases).

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Bond Valuation: Three Important Relationships
Relationship #2
The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate.
Bond will be valued above par value if the investor’s required rate of return is below the coupon interest rate.

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Discount Bonds
The market value of a bond will be below the par when the investor’s required rate is greater than the coupon interest rate. These bonds are known as discount bonds.

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Premium Bonds
The market value of a bond will be above the par or face value when the investor’s required rate is lower than the coupon interest rate. These bonds are known as premium bonds.
If investor’s required rate of return is equal to the coupon interest rate, the bonds will trade at par.

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Bond Valuation: Three Important Relationships
Relationship #3
Long-term bonds have greater interest rate risk than do short-term bonds.
In other words, a change in interest rate will have relatively greater impact on long-term bonds.

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Main Risks for Bondholders
Interest rate risk (if interest rates rise, the market value of bonds will fall)
Default risk (this may mean no or partial payment on debt as in bankruptcy cases)
Call risk (if bonds are called before maturity date)… bonds are generally called when interest rates decrease. Thus, investors will have to reinvest the money received from the corporation at a lower rate.

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Key Terms
Behavioral finance
Bond
Book value
Callable bond
Call protection period
Convertible bond
Coupon interest rate
Current yield
Debenture
Discount bond
Efficient market
Eurobond
Expected rate of return
Fixed-rate bond
Fair value

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Key Terms
High-yield bond
Indenture
Interest rate risk
Intrinsic value
Junk bond
Liquidation value
Market value
Maturity
Mortgage bond
Par value
Premium bond
Subordinated debentures
Yield to maturity
Zero coupon bond

Problem 9-1

)

,942

									Problem 9-1:	Chapter	15
Cash Conversion Cycle
Given the following information: (Amounts in 000’s				SAR
				20		20X2	20X3	20X4
Sales – net	4,250	5,314	7,877				10
Cost of goods sold	2,975	3,720	5,514	7,659
Accounts receivable	618	799	1,091	1,348
Inventories	332	4	45	639	382
Accounts payable	425	670	704	1,555
Calculate for each year:
(1) Days sales outstanding	53.08	54.88	50.55	44.97	Days of saled outstanding = (account Receivable) / (Daily Sales)
(2) Days of sales in inventory	40.73	43.66	42.	30	18.20	Days of sales in inventory = (Inventories) / (daily CODS)
(3) Days payable outstanding	52.14	65.74	46.	60	74.11	Days payable outstanding = (account Payable) / (daily COGS)
(4) Cash conversion cycle	41.67	32.80	46.25	(10.93)	Cash conversion cycle = Days sales outstanding + Days of sales in inventory – Days payable outstanding

Problem 9-2

SAR

SAR Percentage SAR Percentage SAR Percentage

100.00%

20X1 20X2 20X3 20X4

[$SAR] 400

900

27.27%

Fixed assets

[$SAR] 1,300

[$SAR] 1,700

[$SAR] 2,100

Total assets

[$SAR] 2,100

400 800 1,200

100.00%

Long-term liabilities 900 900 900 900

20×1 20×2 20×3 20×4

2,000 2,100 2,200 2,300

Current Ratio Dept Ratio Current Ratio Dept Ratio Current Ratio Dept Ratio

3,300 3,800 4,300 4,800

39%

2.25 39%

45% 3.75 49%

52%

Problem 9-2:		Chapter 15	Part (1)		20×1		20×2		20×3		20×4
Short-term vs. long-term financing				Percentage
Medina Hardware operates many hardware stores and is planning to expand to other areas. The firm has historically reinvested earnings and borrowed using short-term borrowing.	current assets						900		27.2	7%	1200	31.5			8%	1500	34.88%	1	800	37.50%
	Fixed assets	2	400	72.7	3%	2600	68.4	2%	2800	65.12%	3000	62.50%
Recent financial results are as follows: (All amounts in 000’s SAR)		Total assets	3300								100.00%	3800	4300	4800
Liabilities (dept) and Equity
current liabilities				[$SAR] 400	12.12%	10.53%	9.30%	8.33%
Current assets		1,200	1,500	1,800		Long-term liabilities	[$SAR] 900		[$SAR] 1,300	34.2	1%		[$SAR] 1,700	39.53%		[$SAR]	2,100	4	3.75
2,400	2,600	2,800	3,000	Total liabilities	39.		39%	44.7		4%	48.84%	[$SAR] 2,500	52.08%
	3,300		3,800		4,300		4,800	stockholders’ equity	[$SAR]	2,000	60.61%	55.2			6%	[$SAR]	2,200	51.16%	[$SAR]	2,300	47.92%
Current liabilities	1,600	Total liabilities and equity	[$SAR] 3,300	[$SAR] 3,800	[$SAR] 4,300	[$SAR] 4,800
Part (2-3)
Owner’s equity				Current Ratio				Dept Ratio
Total liabilities & equity	First Scenario		2.25	1.50		4	5%	1.25		49%	1.13		52%
Second Scenario	3.00	4.50
(1) Prepare new balance sheet information assuming current liabilities remain unchanged at 400 SAR each year and the 400 SAR increase in debt is added to long-term liabilities.	Current Ratio = Current Assets / Current Liabilities
Dept Ratio = Total Dept / Total Assets
(2) Calculate the current ratio and debt ratio for each year under the first scenario.
(3) Calculate the current ratio and debt ratio for each year under your revised scenario with the additional debt added to long-term liabilities.
(4) Explain which of the two alternatives is riskier and why.	Part (4) from claculated Current Ratio, higher current ratio will lead to have lower risk for investment that means the firm can increase the asset according to the debt, similar meaning that the firm will have more ability to meet its debt

Problem 9-3

Chapter 15

1% 10 30

2% 15 45

3% 15 60

Problem 9-3: Cost of trade credit
Using a 360-day year, compute the cost of trade credit for each of the following:
% Discount	Discount Period (days)	Period after discount (days)	Cost of Trade Credit
(1) 1/10, net 30	18.18%	APR = discount / principle x 1 / (period in days)
(2) 2/15, net 45	24.49%		where:
(3) 3/15, net 60	24.74%	principle = 1 – discount in decimal
period = (net days – days with discount) / 360

Problem 9-4

6% 10 8%

10,000 6% 10 7%

Annually 10,000 4% 15 5%

Semi-annually 10,000 8% 20

Semi-annually 10,000 8% 20 6%

Problem 9-4: Bond valuation		Chapter 7
Calculate the value of the bonds in each situation below:
Interest Paid	Par/Face Value (SAR)		Coupon Rate	Years to maturity	Current intrest rates	Bond Valuation
	Annually						10,000	[$SAR] 8,657.98
		Semi-annually	[$SAR] 9,289.38
[$SAR] 8,962.03
10%	[$SAR] 8,284.09
[$SAR] 12,311.48

Problem 9-5

Chapter 7

Coupon Rate

10,000 6% 10

10,000 4% 15

10,000 10,000 8% 20

where:

Problem 9-5: Bond interest rates
What is the current annual interest rate on bonds that sell for the following?
Current Price (SAR)	Par/Face value (SAR)	Years to Maturity	Current Annual intrest rate
12,842	2.72%	Current Annual Interest Rate =RATE(number of years,annual intrest payment,present value,future value, 0)
7,850	6.25%
8.00%
annual interest payment = coupon rate x face value

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