Hey guys, so I know this isn't a homework help place, but I can't figure out this problem. I was wondering if someone could provide some insight on how to approach this problem. Here it is:
You are the owner of 100 bonds issued by Euler, Ltd. These bonds have 8 years remaining to maturity, an annual coupon payment of $80, and a par value of $1,000. Unfortunately, Euler is on the brink of bankruptcy. The creditors, including yourself, have agreed to a postponement of the next 4 interest payments (otherwise, the next interest payment would have been due in 1 year). The remaining interest payments, for Years 5 through 8, will be made as scheduled. The postponed payments will accrue interest at an annual rate of 6 percent, and they will then be paid as a lump sum at maturity 8 years hence. The required rate of return on these bonds, considering their substantial risk, is now 28 percent. What is the present value of each bond?
Thx for anything.
You can do this! Draw a timeline of all the cashflows as they would be without restructuring the bond ($80 a year for years 1thru 7 and $1080 in year 8.
Then you need to take the cashflows in years 1 through 4 and replace them with their future value equivalent on year eight, using a 6% interest rate.
Now draw your timeline. Your getting $80 in each of years 5 through7, and a whole bunch in year 8 (more than $1400).
Now discount all four of those cash flows to present day, using an interest rate of 28%. And that's your answer!
it's more the fact that he couldn't which worried me.
Thanks JDimon. I tried doing it by using the basic formula that a bond price= sum of all coupon payments + face value. So I compounded 80 dollars four times for years 1-4. Then I took that sum and added it at the end, but I got a number that was way too big. Was my reasoning way off? Thanks
Umm well your answer should be less than $1000 (probably significantly less). Did you remember to discout everything back at 28%?
I got 1,429.96.. Why discount back at 28%? Sorry this is like my 2nd week of finance.
Thanks.
Why 28%? Hmmm... because the question states clearly that this is the required return aka discount rate you are supposed to use.
Granted 28% is usually considered a rather hefty return hurdle in the real world but then this is a hypothetical textbook exercise so we don't really know the circumstance that lends to the justification of the usage of such a figure.
Fixed
The present value of this bond is what you determine the liquidation value of the bond to be, discounted by a rate you deem fair, by when you think it's going bankrupt. If a bond is yielding 28%, it IS going bankrupt. So, if you determine the liquidation value is 20 and it's going bankrupt in 18 months, you probably want to pay 10 for it. You can tell your professor to go fuck himself, he's not living in the real world.
You are right. I didn't read the whole question. Just saw the 28% part. So yeah this scenario is highly unrealistic and makes little sense in the real world.
It's like the stats professor who asks "a guy flipping a coin has flipped 30 heads in a row. What are the odds of getting heads on the next throw?". He actually expects you to answer 50/50 and doesn't consider that getting 30 heads in a row is something like a 1 in a billion chance that would occur if the coin is fairly weighted. I would think there is a much higher chance that the coin is weighted. That is what I find irritating.
Also, to be fair, I should have said discounted until the time when you expect to get paid the liquidation value, not when they declare bankruptcy.
You should be getting something below $300, to give you an idea (without giving you the answer).
1.28 ^ 8 is 7.21...that final year's cash flow (a little over 1500) should be discounted to just over $200.
$251.5509
I totally hear you SirTradesaLot, but I think its the lack of real world sensibility that would drive someone to join academia in the first place...
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