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Types of yield curve

CASE #4

Elizabeth has graduated from UCSD and is now employed as a financial analyst at Qualcomm. She has been assigned to the treasury department. Elizabeth’s boss is convinced, based on current economic data available to him, that interest rates will increase for the next 8 quarters. Given the increase in rates as well as the opening of the credit markets and current projects underway Qualcomm is looking to issue debt. Goldman Sachs, Qualcomm’s investment bank, has informed the company that they are able to issue bonds at 150 basis points over the yield curve for maturities of 5 years or less and 175 basis points over the yield curve for maturities greater than 5 years up to 10 years. Bond issuance costs are estimated at 1.5%. Given this scenario he has asked Elizabeth to do the following:

1) Calculate the current yield curve based on the information provided below.
2) What type of yield curve is it?
3) Calculate the borrowing costs for Qualcomm for the various maturities.
4) Given the premise that interest rates will increase, what should Elizabeth recommend to her boss? What maturity bonds should Qualcomm issue?

Yield Curve Information

Name Maturity Coupon Price
US Treasury 1 year 9% 99
US Treasury 3 years 7.5% 99
US Treasury 5 years 6% 99
US Treasury 7 years 5.5% 98
US Treasury 10 years 5.0% 97

Instructions

Summary

What we are attempting to do is to find the all in cost to issue the various bonds for Qualcomm.

Step 1

Calculate the yield to maturity for each Treasury Note as given above. Remember that they pay interest semi-annually. This means we multiply the # of years until maturity by two and divide the coupon by 2. The PV is the price of the bond and the FV is 100.

Step 2

Add the spread to Treasuries. A basis point is .01% so 175 basis points is 1.75%. Add the appropriate spreads to the yields you calculated in Step 1. These become the coupons on the bonds.

Step 3

When Qualcomm issues bonds they have to pay the associated investment banking fees and legal costs. These are the bond issuance costs and are estimated to be 1.5%. This means that Qualcomm will only receive 100-1.5 or 98.5% of the funds raised.

Step 4

Since we only receive 98.5% of the funds due to the bond issuance costs we need to calculate what the all in cost of the financing is for Qualcomm for each of the maturities.
Remember that n= maturity x 2. Coupon is determined in Step 2 above. PV = 98.5 and FV=100. In each case you are solving for i.