Question

Andrew Industries is contemplating issuing a 30 -year bond with a coupon rate of 7.13% (annual coupon payments) and a face value of $1,000 Andrew believes it can get a rating of A from Standard \& Poor's. However, due to recent financial difficulties at the company, Standard \& Poor's is warning that it may downgrade Andrew Industries' bonds to BBB. Yields on A-rated, long-term bonds are currently 6.41%, and yields on BBB-rated bonds are 6.82%.

a. What is the price of the bond if Andrew Industries maintains the A rating for the bond issue?
b. What will be the price of the bond if it is downgraded?

Answer 1

a. The price of the bond if Andrew Industries maintains the A rating for the bond issue will be $1,000.08. b. The price of the bond if it is downgraded to BBB will be $963.19.

Step-by-step explanation:

a. The price of the bond can be calculated using the formula for the present value of a bond. The present value of the bond is the present value of the annual coupon payments plus the present value of the face value. The present value of the annual coupon payments can be calculated using the coupon rate and the yield on A-rated bonds, and the present value of the face value can be calculated using the yield on A-rated bonds. Using these values, the price of the bond is calculated as follows:

Price = (Coupon payment / Yield on A-rated bonds) * (1 - (1 / (1 + Yield on A-rated bonds)^Number of years)) + (Face value / (1 + Yield on A-rated bonds)^Number of years)

Plugging in the values, the price of the bond is:

Price = (71.3 / 0.0641) * (1 - (1 / (1 + 0.0641)^30)) + (1000 / (1 + 0.0641)^30) = $1,000.08

Therefore, the price of the bond if Andrew Industries maintains the A rating for the bond issue will be $1,000.08.

b. If the bond is downgraded to BBB, the yield on BBB-rated bonds will be used to calculate the price of the bond. We can use the same formula as before, but with the yield on BBB-rated bonds instead. Plugging in the values, the price of the bond is:

Price = (71.3 / 0.0682) * (1 - (1 / (1 + 0.0682)^30)) + (1000 / (1 + 0.0682)^30) = $963.19

Therefore, the price of the bond if it is downgraded to BBB will be $963.19.