INV3702 ASSIGNMENT 2 2021

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INV3702 ASSIGNMENT 2
2021

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QUESTION 1

Determine whether Bond E is overvalued, undervalued or fairly valued. All coupons are
paid annually.

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The price of the 3-year coupon bond (as a percent of par) is:

N = 3; I/YR = 2.711; PMT = 5; FV = 100;

Compute PV = –106.51

The no-arbitrage price of the 3-year coupon bond based on spot (zero-coupon) rates is:

106.51

Therefore the 3-year coupon bond's price equals its no-arbitrage value, therefore the bond
is fairly valued.

QUESTION 2

Explain to Kgomotso why her method leads to an incorrect answer, and advise her on the
correct method to approach this question. No calculations are necessary.

Kgomotso’s method uses the yield-to-maturity as the input for I/YR.

Yield-to-maturity is not appropriate for arbitrage-free valuation when the yield curve is not
flat.

She should value each cash flow separately using the corresponding spot rate.

Full marks for the correct equation:

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QUESTION 3

Explain in full why you either agree or disagree with Khumalo’s suggestion.

Disagree

 An inverted or downward-sloping yield curve, under the pure expectations theory,

indicates that short-term rates are expected to decline in the future.
 Bonds with lower coupons have higher duration, all else equal.
 In a declining interest rate environment bond prices increase, and bonds with higher
duration (interest-rate sensitivity) increase by more.

QUESTION 4

Calculate adjusted financial ratios for both companies and the industry, and evaluate the
relative creditworthiness of Company Y and Company Z.

The recommended analyst adjustments are to add the present value of operating lease
obligations and net pension liabilities to total debt before calculating leverage ratios.
An analyst should also consider total capital both including and excluding goodwill.

The following table shows the results of these analyst adjustments:

COMPANY Y COMPANY Z INDUSTRY AVERAGE

EBIT 550 000 2 250 000 1 400 000
Funds from operations 300 000 850 000 600 000
Interest Expense 40 000 160 000 100 000
1 300 000 2 700 000 2 600 000
Total Debt
[1 000 000 + 300 000] [2 500 000 + 200 000] [2 400 000 + 200 000]
Total Capital
4 000 000 6 500 000 6 000 000
(including goodwill)
Total Capital 3 500 000 5 800 000
6 500 000
(excluding goodwill) [4 000 000 – 500 000] [6 000 000 – 200 000]

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CALCULATIONS:

Leverage and coverage ratios such as EBIT/Interest, FFO/Total Debt, and Total debt/total
capital based on the adjusted data are given below:

RATIOS COMPANY Y COMPANY Z INDUSTRY AVERAGE

13.75 14.06 14
EBIT/Interest
[550 000 ÷ 40 000] [2 250 000 ÷ 160 000] [1 400 000 ÷ 100 000]
23.08% 31.48% 23.08%
FFO/Total Debt
[300 000 ÷ 1 300 000] [850 000 ÷ 2 700 000] [600 000 ÷ 2 600 000]
32.5% 41.54% 43.33%
Total Debt/Total Capital
(including goodwill)
[1 300 000 ÷ 4 000 000] [2 700 000 ÷ 6 500 000] [2 600 000 ÷ 6 000 000]
37.14% 41.54% 44.83%
Total Debt/Total Capital
(excluding goodwill)
[1 300 000 ÷ 3 500 000] [2 700 000 ÷ 6 500 000] [2 600 000 ÷ 5 800 000]

 Both Company Y and Company Z have interest coverage in line with their industry
average
 Company Z’s funds from operations relative to its debt level are greater than the
industry average, while Company Y is generating less FFO relative to its debt level.
 Company Z is more leveraged than Company Y (but less than the Industry
Average), especially after adjusting for goodwill.

Based on these data, Company Y appears to be more creditworthy than Company Z.

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QUESTION 5

If the future spot rates are expected to be lower than the current forward rates for the
same maturities, are bonds most likely to be overvalued, undervalued, or correctly
valued? Justify your answer.

If an investor believes that future spot rates will be lower than the current forward rates,
then the investor will perceive an opportunity to purchase bonds at an attractive price, as
the market is discounting future cash flows at “too high” a discount rate.

The bonds are thus undervalued in the market.

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QUESTION 6

Use a binomial interest rate tree with the following rates to value a three-year, 3%
annual-pay option-free Treasury bond with a R100 par value.

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PLEASE DO NOT PLAGIARISE!!

USE FOR COMPARISON

ONLY!!

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