A company, Prabhat Engineering is planning to invest in the 8%, 25-year, Rs 1,000 debentures of Flex Engineering. The latter had issued those debentures 5 years ago. They are convertible into 50 equity shares and can be called any time at Rs 1,079.
It may be pointed out the current rate of inflation is 4.40 per cent and is likely to be 5.0 per cent annually. Thus inflation is a problem accompanied by the long maturity that is fraught with risk Alternatively, Prabhat Engineering has access to make investment in another issue of debentures made by Rahul Engineering that have 10 per cent coupon, 10-year maturity, Rs 1,000 par value and a semi-annual interest payment. In order to reach a decision whether to invest and where to invest, Prabhat Engineering goes for valuing the bond.
1. If the market price of the equity share rises by Rs 25 per share after 3 years, will it be advisable for Flex Engineering to call the debentures?
2. Compare the two alternatives where Prabhat Engineering chould make investment.
3. If Prabhat Engineering goes for the first alternative and holds the debentures for 3 years, how much gain/loss will it experience in the value of debentures?