Swan Davis

Introduction

SDI manufactures equipment for sale to large contractors. SDI’s financial performance has been disappointing. Tony Biddle and other analysts expect the firm to cut the annual dividend in 1997. If their forecasts are correct, the company is expected to grow at a rate of 14.9% and they think that the P/E ratio will increase to 15. SDI’s poor performance was cause by stock price declines which resulted from poor operating results. The goal is to estimate the companys cost of debt, preferred stock, and a good cost of capital estimate for evaluating proposed capital expenditures.

Answers to questions

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

A bond's YTM would be 8.61%. FV = $1000 PV = $1092 Payment semiannually = $50

N = 10 Coupon rate = 10%

2. Like many others bonds, SDI’s A bonds have a call provision. What is the yield to call on this issue? Which return would an investor be more likely to receive on this bond if it were purchased today, the YTM or the YTC?

a. What is the yield to call on this issue? The yield to call is 6.9%

b. Which return would an investor be more likely to receive on this bond if it were purchases today, the YTM or the YTC?

The investor would most likely get the YTC at 6.90%

3. Bond prices and returns vary over time due to changes in a company’s risk situation and in response to market factors such as inflation. How would changes in inflation affect the price and the return required on the A bonds? If SDI’s risk as perceived by investors increases, what would happen to the price and the required return on these bonds? What effect would such changes have on SDI’s capital budgeting decisions?

a. How would changes in inflation affect the price and the return required on the A bonds?

Rate of inflation is inversely proportional to the bond price. An increase in interest rate will lead to a decline in the present value of a bond. As the rate...