Question

Recently, Midrand Hospitals Inc. filed for bankruptcy. The firm was reorganized as American Hospitals Inc., and the court permitted a new indenture on an outstanding bond issue to be put into effect. The issue has 10 years to maturity and a coupon rate of 10 percent, paid annually. The new agreement allows the firm to pay no interest for 5 years. Then, interest payments will be resumed for the next 5 years. Finally, at maturity (Year 10), the principal plus the interest that was not paid during the first 5 years will be paid. However, no interest will be paid on the deferred interest. If the required annual return is 20 percent, what should the bonds sell for in the market today?

Answer 1

year 1-5: $0 per annum

year6-10: $100 per annum coupon payments

Year 10:Par value+deferred interest for the 1st 5 years

=1,000+(5$\times$100) =1,500

The required rate of return is to 0.2% per annum

The PV of the cash-flows will be ;

PV of the coupon payments + PV of the par value plus deffred interest

=100$\times$PV Annuity Factor for 5 periods at 20%$\times$PV Interest factor with i=20% and n =5$ plus 1,500×PV Interest factor with i=20% and n =10

Thus the bonds should sell for ;

= $100\times \frac{[1-(1+0.2)]}{0.2(1+0.2)^{-5} }+\frac{1,500}{(1+0.2)^{10}}$

= $362.4

Thus the bonds should sell for $362.4 in the market today.