Question

CASE:

Atlantic Airlines Case Atlantic Airlines issued $100 million in bonds in 2008. Because of the firm's low credit rating (B3), the bonds were considered junk bonds. At the time of the issue, the 20 year bonds were paying a yield of 12 percent. Investor Tom Phillips thought the yield on the bonds was particularly attractive and called his broker, roger Brown, to ask for more information on the debt issue. Tom currently held Treasury bonds paying four (4) percent interest and corporate bonds yielding six (6) percent. He wondered why the debt issue of Atlantic Airlines was paying twice that of his other corporate bonds and eight (8) percent more than Treasury securities. His broker, Roger Brown has been a financial consultant with Merrill Lynch for 10 years and was frequently asked such questions about yield. He explained to Tom that the bonds were not considered investment grade because of the industry they were in. Bonds of airlines are considered inherently risky because of exposure to volatile energy prices and the high debt level that many airlines carry. He further explained that they frequently were labeled ""junk bonds"" because their rating did not fall into the four highest categories of ratings by the bond rating agencies of Moody's and Standard and Poor's. Questions from Tom Phillips This explanation did not deter Tom from showing continued interest. In fact, he could hardly wait to get his hands on the 12 percent yielding securities. First, he asked Roger, What is the true risk and is it worth taking? Roger explained there was a higher risk of default on junk bonds. It sometimes ran as high as 2-3 percent during severe economic downturns (compared to.5 percent for more conventional issues). Roger also indicated that although the yield at the time of issue appeared high, it could go considerably higher should conditions worsen in the airline industry. This would take place if the price of oil moved sharply upward or people began flying less due to a downturn in the economy. Roger explained that if the yield (required return) on bonds of this nature went up, the price of the bonds would go down and could potentially wipe out the high interest payment advantage.

QUESTIONS

Please share formula examples that was used in Excel.

Problem Set 6 – Atlantic Airlines

Read “Case 15 – Atlantic Airlines” and answer the following questions for the case. For these problems,

assume there are 18 years left on the bonds and the year is 2010. The bond amount is $100 million.

1. Assume the year is 2010 and there are 18 years left on the bonds that are paying a yield of 12%

annually. What is the interest payment each year?

2. What is the present value of the interest payments if the bond yield is 12% and if the current yield to

maturity on such bonds is 9%?

3. What does the present value of the interest payments represent?

4. Assume that Roger is correct and that the higher risk of default on junk bonds and conditions in the

airline industry causes the market for the bonds to go to a yield of 15%. What is the new price of the

bonds paying a yield of 12% annually?

5. What does a credit rating of B3 mean? What ratings are higher than B3? Here are some sources to help

you answer these questions:

http://www.investopedia.com/terms/b/bondrating.asp;

http://www.investopedia.com/terms/b/b3-b.asp

6. Assume that you are Tom’s financial advisor. What would you recommend that Tom do?

Answer 1

Ans 1) Interest payment each year will be = 12% of 100Million = $12Million

Ans 2) Present value of interest payments = present value of bond - $100million /1.09^18 = $126.27Million - $21.2 Million = $105.07 million

Ans 3) Present value of interest payments represents the present value of all the future interest payments which will happen in subsequesnt years.

Ans 4) Present Value of bond = 12 Million/1.15 + ................+ 112Million/1.15^18 = $81.61 Million

Ans 5) B3 is a credit rating given to non prime bond by Fitch. B2, B1, A1, A2 etc are some higher credit ratings given by rating agencies.

Ans 6) I would recommend him as per his risk appetite if he is rich client and there is not much obligations with him then I will recommend this bond otherwise I will recommend some safer alternative to him.