Ms

INTRODUCTION

- The Swan Davis Corporation case focuses on following issues:

* The importance in bond and stock valuation;

* The capital structure of the company; and

* How they effects to the capital budgeting decisions of the company.

- Swan- Davis Inc., (SDI) manufactures equipment for sale to large contractors, the company was found in 1976 and it went to the public in 1980 at its shares value risen from $1 to $15 since it enter to the market.

- The financial statements for the past three years show a decline trend in both the operation and return on shareholder of the company, so a closer look at the factors contributing to this decline is needed.

- The capital structure of company mainly constitutes of:

1. Deb

a. Bond A which is activities trade and highly liquid, issued 10 years ago, and it has 10 years to maturity.

b. Bond B which is thinly traded and no valid market quotation is available; it has 23 years to maturity more.

2. Preferred stock

3. Equity - Stock and retained earning.

Question 1:

If an investor bought some of SDI's A bonds at the current market price, what would be his/her yield to maturity?

Look at the case concerns, bond A has a $1000 par value and coupon rate is 10%, pail semiannually. The bond was issued 10 years ago, and has 10 years to maturity; current market price is $1092.

Input data Calculation result is compounded semiannually

Par value (FV) = $1,000

Coupon rate = 10%

Payment annually = $100

Present value= $1092

Year to call=10

Payment semiannually = $50

N = 10

Formula: PV=

Yield to maturity (YTM) is: 8.6%

Question 2:

From the data of the case we can calculate the current yield to call of bond A, which is equal annually coupon payment divided by the bond's current price is 9.16%

After 1994, because of financial problems the company' bond were downgraded and rated BB by S&P, a return reasonable rate for bond A is 8.8% is implied in the Bond Guide.

If the YTM is 8.8%, the Present value of bond A is $ 1078.72, so the bond is trading at the price $1092 higher than its expected value and is overvalued

Yield to call: the bond has 2 years of call provision left, and after that it can be called at 104% of par is $1040.

Using given data

Input data Calculation result is compounded semiannually

Coupon rate = 10%

Payment annually = $100

Present value (PV)= - $1092

N=2

Future value (FV)= $1040

Payment semiannually = $50

N = 4

Formula:

Yield to call is 6.9%

Investors would be more likely to get return on this bond if it were called to day based on yield to call is 6.9% versus yield to maturity 8.6%

Question 3:

Changing the inflation effect the price and return required on the bond A:

- Interest rate goes up and down over the time, and an increase in interest rate leads to a decline in the value of outstanding bonds, thus investors or firms who invest in the bonds are exposed to risk from changing interest rate. Since the coupon rate for this bond is 10% and current yield to maturity is at 8.6%, this is a significant consideration for initial investors due to the bond's value increase.

- Conversely, that SDI has to pay more than the initiative coupon leads to call the A bond in the next 2 year. When SDI's perceived risk disclosures in the market, A bond rating slips down to a B, the average bond rating. Therefore, SDI would want not to call the bonds and republics them to the market because the return rate is now 11.1% instead of current rate at 10%.

- The rate of inflation is inverse ratio to the bond's price. In term of inflation impact on the firm business, it will affect the purchasing power of dollar and lower the real rate of return on investment. When the inflation goes up, the interest rate consequently increases since the actual interest rate charged would be the real risk-free rate plus the inflation premium (IP):

r = r* + IP

Accordingly, the rate of inflation is inversely proportional to the price of the bond. If the rate of inflation increases, the present value of the bond will decrease. So the rate of inflation plays an important role in the value of a bond.

- Moreover, capital budgeting correlates to security valuation as well when the inflation occurs. For that circumstance, the firm should identify the projects that implement to the firm's value by preparing the portfolio diversifying their products in purpose of appealing to investors. This kind of task requires the firm, especially the marketing research group, to specify the size of market and potential customers to reach their needs.

Question 4:

As the case concerned, the B bond is not actively traded and no valid market quotation is available. The reasonable interest rate to use in valuing the B bonds is calculated as follow:

Using the following give data:

Initiative data Calculation result is compounded semiannually

Par value (FV) = $1,000

Coupon rate = 6.90%

Payment annually = $69

Year to maturity = 25

Year to call = 23

Payment semiannually = $34.5

N