Question

Financial Option 3: $30 Million Investment in Bonds

Rationale for investment: The business is offering these bonds for sale contracts with another business
in China to assemble computer parts. The Chinese business has used child labor in the past, but it claims
it has stopped this practice. However, the U.S. business selling these bonds has not investigated to verify
whether these claims are true.
2
Assumptions to consider:
• 10-year bond
• 8% coupon
• Priced at a discount: $95
• Discount rate is 9%

Answer 1

The value of a bond is calculated by discounting its future interest payments and principal repayment to present value using the market interest rate as the discount rate. Two key examples illustrate how to find the value of bonds considering different interest and discount rates, highlighting the effect of these rates on bond pricing.

Step-by-step explanation:

Calculating Bond Prices with Different Interest Rates:

When assessing the value of a bond with a coupon rate that is different from the market interest rate, we need to calculate the present value of future payments. For example, a two-year bond with a face value of $3,000 and coupon rate of 8% pays $240 in interest each year. The present value of these future payments is calculated by discounting them back to their value today considering the relevant discount rate, which may be the same as or different from the bond's coupon rate.

Present Value Formula:

To calculate the bond's present value at an 8% discount rate, we would use the following formula for each payment:

Present Value of Year 1 Interest: PV = $240 / (1+0.08)

Present Value of Year 2 Interest + Principal: PV = ($240 + $3,000) / (1+0.08)2

Now, to find out the present value at an 11% discount rate, we would adjust the formula:

Present Value of Year 1 Interest: PV = $240 / (1+0.11)

Present Value of Year 2 Interest + Principal: PV = ($240 + $3,000) / (1+0.11)2

Similarly, if we consider a bond with one year remaining at a market interest rate of 12%, expected to pay $1,080, the maximum price a rational investor would pay is the present value of $1,080 discounted at 12%, which equals $964.

For the local water company's bond, if they issued a $10,000 bond at 6% interest but the current market rate is 9%, the bond's price one year before maturity would be calculated by discounting the final year's payment (interest plus principal) at the current market rate of 9%.

Answer 2

Investing in these bonds involves ethical concerns due to the past use of child labor by the Chinese business. The investment offers an 8% coupon rate for a 10-year bond, priced at a $95 discount with a 9% discount rate. However, the U.S. business selling these bonds has not verified if the claims of stopping child labor are true. Investors should consider the ethical implications before investing, as it might support unethical practices despite the financial benefits.

Step-by-step explanation: