- 20 Marks
Question
(a)
Skylet Limited is a major player in the aviation industry with a credit rating of AA. The company plans to raise ₦5 billion from the bond market. The features of the bond are:
- Maturity: 4 years
- Coupon payment: Annual
- Coupon rate: 5%
- Redemption value: Par
The current annual spot yield curve for government bonds is as follows:
| Term | Spot Rate |
|---|---|
| One-year | 3.3% |
| Two-year | 3.8% |
| Three-year | 4.5% |
| Four-year | 5.3% |
The following table of spreads (in basis points) is given for the aviation industry:
| Rating | 1 Year | 2 Year | 3 Year | 4 Year |
|---|---|---|---|---|
| AAA | 12 | 23 | 36 | 50 |
| AA | 27 | 40 | 51 | 60 |
| A | 43 | 55 | 67 | 80 |
You are required to calculate:
i. The issue price of the bond. (6 Marks)
ii. The yield to maturity. (3 Marks)
iii. The duration. (6 Marks)
(b)
Discuss why conflicts of interest might exist between shareholders and bondholders. (5 Marks)
Answer
a)
i) Issue Price
The spot yield curve should be used to calculate a likely issue price. The
government bond yield curve needs to be adjusted by the credit spread for an AA rated company.
(b) Conflicts of Interest Between Shareholders and Bondholders
- Risk Preferences: Shareholders may prefer riskier projects for higher returns, while bondholders favor safe investments to secure debt repayments.
- Dividends: High dividends may benefit shareholders but reduce available funds to pay interest and principal to bondholders.
- Priority in Insolvency: Bondholders have claims over company assets before shareholders, leading to conflicts if insolvency occurs.
- Additional Financing: Shareholders might favor raising funds through debt to avoid equity dilution, increasing financial risk for bondholders.
- Restrictive Covenants: Bondholders may impose restrictions (e.g., limits on dividends or further borrowing), which can constrain shareholder strategies.
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