- How much would you pay for this bond today? Take into consideration your own personal risk preferences, interest rates, inflation, and the probability your company will not be able to pay you back in one year. Note: You do not need any math equations for this part; just explain how much you would personally pay for a $100,000 bond from this company.
Kroger Inc. is a US based retail company which mainly operates in food and grocery retailing. The company is doing very well in recent years growing at a rate of 4% YOY. Kroger wants to float some bond in the market to get some capital which it will use to expand its operation. It will pay $100,000 next year to the bond holders. It is exploring what should be the fair value of those bonds today.
The interest rate prevailing in the market is 4% for Treasury Bonds which are deemed to be risk free investment and so minimum return on investment expected will be 4% in one year (Treasury Yield Curve Rates). However, Kroger bonds are not government bonds and hence it is not as risk free as treasury bonds of municipal bonds. In case of any liquidity issue, my investment will suffer. Some of the company’s financial ratios are not as good compared to its competitors. For Example, the debt/equity ratio for the company is 172 which is very high even within retail industry. The quick ratio is only 0.72 which shows the liquidity issues for Kroger. However, the topline and bottom-line for the company is growing and also is expected to grow in similar lines in coming future (Kroger Financials). As the company’s financial ratios are not great irrespective of its good revenue performance, I would like to have some premium on my investment. I will only invest in Kroger’s bond if I get at least 3% more than the risk free rate.
Inflation seems to be low and is currently at 2.0%. Inflation is slated to go up by another percentage point in next one year as per financial forecasts. If inflation goes up then my money’s worth will be that much less. To account for that I also want 1% more as return on my investment to cover up for inflation (US Inflation calculator).
Overall, if I get a return of 4+3+1= 8% rate of return then I will be willing to invest in the bond. In other words, I will be willing to pay $92592.59 for the bond today.
2) Based on your answer to the previous question, what would be your discount rate for this bond? Use the present value formulas from the background materials and show your work.
I am expecting a return of 4% as minimum as that is risk free rate. I am willing to bet on Kroger Bonds with a premium of 3% as the financial parameters of Kroger is not great compared to its competitors and it is not a highly liquid company. Also the inflation rate is forecasted to grow by 1% in next one year; I want to cover up for that as well.
Overall, 4% (Risk free rate) +3 %( Risk Premium) +1% (Inflation Volatility) = 8% total return on investment is what I will be looking at. So for me discount rate for this bond will be 8%.
Value of the bond after 1 year is = $100,000
Present value of the bond today = $100,000/ (1.08) = $92592.59
3) Pick two other companies in the same industry as your SLP Company. Pick one that you would pay less for a $100,000 bond than you would for your SLP company’s bond, and another that you would pay more for a $100,000 bond you would for your SLP company’s bond. Explain why you would pay more or less for their bonds.
Let’s also look at two other companies in the same industry like Kroger, Wal-Mart and Whole Foods Market. Wal-Mart is the biggest player in the retail industry and in fact the biggest player in the world. It is also a financially sound company as it is growing at a rate more than 4% YOY. The company also has solid plans to grow inorganically and organically in developed market to boost its topline and bottom-line. The debt to equity ratio for the company is 74 and quick ratio is 0.83, both better than Kroger. Ratings for Wal-Mart by Moody’s are as good as investing in municipal bonds (Wal-Mart Financials). Chances that Wal-Mart will default or will be taken over by some other company are negligible. After considering all those, the risk premium for Wal-Mart for me will be 1.5% compared to 3.0 % for Kroger.
So the Discount rate in case of Wal-Mart will be = 4% (Risk free rate) +1.5 %( Risk Premium) +1% (Inflation Volatility) = 6.5%
Present value of a Wal-Mart bond is = $100,000/ (1.065) =$93896.71, so I will be willing to pay a little more for Wal-Mart bonds.
Whole Foods Market is also a successful company in the fresh foods retail market. It is growing at a pace faster than Kroger and Wal-Mart. The long term debt for the company is negligible and debt to equity ratio is best in the industry. Financially the company is doing very well in recent years. From financial perspective the company is a safe investment option. However, one problem the company may face in recent future is aggressive competition from the bigger companies in the fresh foods market which may see some pressure on the company’s topline and bottom-line (Whole Foods Market Financials). Another problem that Whole Foods market may face in recent future is takeover bids from bigger players like Kroger, Safeway and Wal-Mart. In both such cases any return on investment in Whole Foods Market bonds will be uncertain. Risk Premium for me in Whole Foods Market will be 5%.
So the Discount rate in case of Whole Foods Market will be = 4% (Risk free rate) +5 %( Risk Premium) +1% (Inflation Volatility) = 10%
Present value of a Whole Foods Market is = $100,000/ (1.1) =$90909.09, so I will be willing to pay a little less for Whole Foods market bonds than Kroger bonds.
References
The Kroger Co. (KR)-NYSE. Key Statistics. Retrieved on 7th September 2013 from <http://finance.yahoo.com/q/ks?s=KR+Key+Statistics>
Wal-Mart Stores Inc. (WMT) -NYSE. Key Statistics. Retrieved on 7th September 2013 from <http://finance.yahoo.com/q/ks?s=WMT+Key+Statistics>
Whole Foods Market, Inc. (WFM). Key Statistics. Retrieved on 7th September 2013 <http://finance.yahoo.com/q/ks?s=WFM+Key+Statistics>
Historical Inflation Rates: 1914-2013. US Inflation Calculator. Retrieved on 7th September 2013 <http://www.usinflationcalculator.com/inflation/historical-inflation-rates/>
Resource Center. US Department of the Treasury. Retrieved on 7th September 2013 <http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield>
