Lockheed Martin Bonds

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Introduction:

Lockheed martin was formed in 1995 after the merger of two companies namely Lockheed and Marietta. It offers defence and aerospace products and its main competitors include Raytheon and Boeing Company, according to yahoo finance (2010) Lockheed martin (LMT) revenue for the year 2009 was $45 billion, Boeing revenue was $68 billion and Raytheon revenue was $24.88 billion. The following is a discussion of investment decision to made regarding investing in the above named companies:

Part1:

Assuming Lockheed martin offers to pay $1000 for a bond a year from now, the amount to pay for that bond will depend on the expected interest rates change, probability that the company will not pay the amount, inflation and individual risk preference. According to Brick (1996) The

Lockheed Martin Bonds

required rate of return will depend on a number of factors, the rate of return is determined as follows: Required rate of return = real rate of return + inflation premium + risk premium. Brick (1996)

Interest rate:

The rate of interest in this case is the opportunity cost of capital invested; in this case interest rate that could be earned in a bank deposit would be approximately $80

Preference:

There are three type of bonds namely treasury, municipal and corporate bonds, corporate bonds have a higher interest rate than treasury bonds given that there is a default risk involved, no default risk is involved in treasury bonds and therefore their interest rate is lower. In this case therefore the preferred bond would be corporate bonds which have higher interest rates due to default risks involved. Therefore this investment will earn more than $80.

Probability that the company will not pay:

This probability is indicated by the bond rating, according to S$P (2009) website Lockheed martin bond rating is BBB+ which is equivalent to 10.29 %; this means that the probability of the corporation defaulting to pay the amount is 10.29%. Given that the probability that the company will not default is 91.71% then a risk premium value of $50 is added to interest earned.

Lockheed Martin Bonds

Inflation:

Brick (1996) stated that expected changes in interest rates will depend on expected inflation, and this is according to the expectations hypothesis whereby investors demand higher interest rates when inflation goes up, this means that as inflation increases then interest rate also increase, in this case an inflation premium is added to interest rate to cater for expected inflation, the assumed inflation premium value in this case is $50.

Value of the bond today:

From the above analysis the total interest to be earned from the bond will be an addition of real returns value of $50 plus inflation premium value of $50 plus a risk premium of $50, total interest value is 150, therefore the amount I would be willing to pay for this bond is: $1000 – $150 = $850

Part 2:

This part analyses the discount rate of the bond given that the future value is $1,000 and the present value of the bond is $850.

Bond discount rate:

The present value is calculated as follows: Brick (1996)

Lockheed Martin Bonds

PV= FV/ (1+r) n

Given n = 1, discount rate r which is unknown, future value FV = 1000 and present value PV = 850, the discount rate is determined as follows:

850= 1000/ (1+r) 1

850(1+R) =1000

850+850R=1000

850R=1000-850

850R=150

R=0.176470588

Therefore the bond discount rate is 17.65%

Answer: 17.65%

Lockheed Martin Bonds

Part 3:

This part analysis two companies in the same industry that I would be willing to pay more and one that I would be willing to pay less for the $1000 bond, Two other companies in the same industry selected include Boeing and Raytheon corporation, from yahoo finance Lockheed Martin revenue growth in sales was 12.5%, Boeing revenue growth was 41.6% and Raytheon revenue growth was 9.5%, this indicates that Boeing is the best company to invest in, bond rating of these companies differ, Boeing bond rating is AA and this means that the probability of default is 1.5%, Raytheon on the other hand bond rating is BB and this mean that the probability of default is 29.93%.

Using the probability of default it is evident that I would prefer to pay more for Boeing bonds that Raytheon bonds, the reason is because the probability of default in Raytheon is higher. This means that the risk premium to be is relatively higher for Raytheon bonds and for this reason I would be willing to pay less, the table below summarises the results:

Lockheed martin

Returns value of $50

Inflation premium value of $50

Bond rating BBB+, therefore risk premium $50

Risk premium of $50

Lockheed Martin Bonds

Required returns = 50+ 50+ 50 = 150

Amount to pay

$1000 – $150 = $850

Boeing

Returns value of $50

Inflation premium value of $50

Bond rating AA, therefore risk premium $20

Risk premium of $20

Required returns = 50+ 50+ 20 = 120

Amount to pay

$1000 – $120 = $880

Lockheed Martin Bonds

Raytheon

Inflation premium value of $50

Bond rating BB, therefore risk premium $80

Risk premium of $80

Required returns = 50+ 50+ 80 = 180

Amount to pay

$1000 – $180 = $820

From the above calculation it is evident that Raytheon bond rating increases the risk premium and therefore I will be willing to pay less for the 1000 bond, Boeing bond rating reduces the risk premium and therefore I will be willing to pay more for the 1000 bond.

References:

Lockheed Martin Bonds

John Brick (1996) Financial markets: instruments and concepts, New York: McGraw Hill press

S$P website (2009) Bond rating for Raytheon, Boeing and Lockheed Martin, Retrieved on 7th February, from

http://www.standardandpoors.com/ratings/corporate/en/u

Yahoo finance (2009) Lockheed Martin, Raytheon and Boeing, Retrieved on 7th February, http:

//finance.yahoo.com/q/co?s=LMT