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Name : Wawan Hafid Syaifudin

ACTSC 611 project


Suppose you are an intern with a company. The firm is planning to issue $50 million of 12%
annual coupon bond with a ten-year maturity. The firm anticipates an increase in its bond rating.
Your boss wants you to determine the gain in the proceeds of the new issue if the issue is rated above
the firm’s current bond rating. To prepare this information, you will have to determine the firm’s
current debt rating and the yield curve for their particular rating.
1. The current U.S. Treasury yield curves and the yield spreads for the various bond ratings are
provided in the excel file “Data”.
2. For the current bond rating of the firm, you can pick any company and find its rating on Standard
& Poor’s website, or just simply assume the rating for an imaginary company.
3. You are given that the yield curve (plotted with the spot rates) for a corporate bond is higher than
the treasury yield curve (which is considered to be risk free). The difference between the two
yields is called the yield spread or credit spread.
4. When constructing the treasury yield curve, you can either use the average of the given data or any
method that has a reasonable explanation.
5. For the spot rates not available from the given data, use the linear interpolation to fill the gaps.
What you need to do:
(i) Produce the treasury yield curve of your choice. Explain your method.
In producing the yield curve, we use the average of the given data. The yield curve can be seen
below.

US Treasury Yield Curve


3
Percentage Nominal Rate

2.5

1.5

0.5

0
1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
(ii) Produce the yield curve (using spot rates) of the firm under the current rating and explain your
method. Compute the issue price of the bond and its initial yield to maturity.
We are given the data below:
Outstanding = $50,000,000
Face Value = 1,000 (assumption)
Quantity of Bond = $50 million/Face Value = 50,000 bonds
Annual coupon rate = 12%
Maturity = 10 years

In this case, we pick the company with the rating of Baa2/BBB. We will calculate the treasury
yield rate (which is considered to be risk free), yield spread, and the spot rate. For the data
which are not given in the table, we use the linear interpolation to fill the gaps.
We use excell program to calculate all the rates.
The result of the calculation can be seen on the table below (all the data are in percentage).

DISCOUNT RATE

Year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 year
Risk Free Rate
1.547059 1.681176 1.791706 1.916147 2.040588 2.132647 2.224706 2.266863 2.309019 2.351176
(Average)
Corporate Bond Spread
0.47 0.952 1.094 1.184 1.274 1.334 1.394 1.435333 1.476667 1.518
(Rating Baa2/BBB)
Spot Rate 2.017059 2.633176 2.885706 3.100147 3.314588 3.466647 3.618706 3.702196 3.785686 3.869176

The yield curve (using spot rates) of the firm under the current rating can be seen on the graph
below:

Yield Curve (Current Spot Rates)


4.5
Current Spot Rates (Percentage)

4
3.5
3
2.5
2
1.5
1
0.5
0
1yr 2yr 3yr 4yr 5yr 6yr 7yr 8yr 9yr 10yr
Next, we will compute the issue price of the bond and its initial yield to maturity. In this part,
we will calculate the present value of each payment at time 0.

CASH FLOW
Year 1 2 3 4 5 6 7 8 9 10
Payment 120 120 120 120 120 120 120 120 120 1120
PV of Payment 117.6273 113.9215 110.1834 106.2048 101.9467 97.80904 93.56514 89.71759 85.8903 766.2159

Issue Price 1683.0817


YTM 3.702488%
Cash 84154085.18

Formula for the calculation above:


Payment = Face Value ∗ Coupon
Payment at maturity = Face Value ∗ (1 + Coupon)
Spot rate = Risk free rate + Corporate Bond Spread
Issue Price = PV of all payment

Therefore, we can obtain the issue price of each bond is $1,683.0817


The initial yield to maturity is 3.702488%
Total cash needed is $84,154,085.18

(iii) Assume the rating of the firm will be increased by one level. Produce the new yield curve
(using spot rates) for this firm. Compute the new bond price and yield based on the higher
rating.
By assuming that the rating of the firm will be increased by one level, it means that we pick the
company with the rating of Baa1/BBB+. We will calculate the treasury yield rate (which is
considered to be risk free), yield spread, and the spot rate. For the data which are not given in
the table, we use the linear interpolation to fill the gaps.
We use excell program to calculate all the rates.

The result of the calculation can be seen on the table below (all the data are in percentage).
NEW BOND RATING (Rating Baa1/BBB+):

DISCOUNT RATE
Year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 year
Risk Free Rate
1.547059 1.681176 1.791706 1.916147 2.040588 2.132647 2.224706 2.266863 2.309019 2.351176
(Average)
Corporate Bond Spread
0.578 0.8 0.93 1.012 1.094 1.147 1.2 1.239333 1.278667 1.318
(Rating Baa1/BBB+)
Spot Rate 2.125059 2.481176 2.721706 2.928147 3.134588 3.279647 3.424706 3.506196 3.587686 3.669176

The new yield curve (using spot rates) of the firm under the new rating can be seen on the
graph below:

Yield Curve (New Spot Rates)


4
3.5
New Spot Rates (Percentage)

3
2.5
2
1.5
1
0.5
0
1yr 2yr 3yr 4yr 5yr 6yr 7yr 8yr 9yr 10yr

Next, we will compute the issue price of the bond and its initial yield to maturity. In this part,
we will calculate the present value of each payment at time 0.

CASH FLOW

Year 1 2 3 4 5 6 7 8 9 10
Payment 120 120 120 120 120 120 120 120 120 1120
PV of Payment 117.502992 114.2597 110.712 106.9165 102.8394 98.87643 94.80062 91.08576 87.3792 781.1268

Issue Price 1705.49937


YTM 3.511893%
Cash 85274968.45
Formula for the calculation above:
Payment = Face Value ∗ Coupon
Payment at maturity = Face Value ∗ (1 + Coupon)
Spot rate = Risk free rate + Corporate Bond Spread
Issue Price = PV of all payment

Therefore, we can obtain the new issue price of each bond is $1,705.49937
The new yield to maturity is 3.511893%
Total cash needed is $85,274,968.45

(iv) Compute the additional cash proceeds that could be raised from the issue if the rating were
improved.

The additional cash proceeds that could be raised from the issue if the rating were improved
can be obtained by this formula :
Additional Cash = (Cash for Baa1/BBB+) − (Cash for Baa2/BBB)

Summary:
Cash for Baa2/BBB 84154085.18
Cash for Baa1/BBB+ 85274968.45
Additional Cash 1120883.271
Cash Increase 0.013319416
Cash Increase in Percentage 1.331941603

Therefore, we can obtain that the additional cash that could be raised from the issue if the rating
were improved is $1,120,883.271. It means that there will be an increase of 1.331941603% in
cash.