T. Rowe Price Associates
8 Pages Posted: 21 Oct 2008
Peter Gordon, manager of a $1.6 billion investment in municipal securities at Price, has just received phone calls from the sales representatives of two investment banks, each offering attractive opportunities for the reinvestment of $50 million that will shortly become available. He may choose either but not both of the offers. The case can be used to review the contents of a "tombstone," to reinforce NPV and IRR concepts, to witness the inappropriateness of using IRR as a selection criterion among mutually exclusive projects, and to emphasize the reinvestment assumption of IRR.
T. ROWE PRICE ASSOCIATES
Peter Gordon's day had begun as usual, with the Wall Street Journal. As was his custom, he had started reading at the back, but he had not yet finished “Heard on the Street,” when his direct lines to Salomon Brothers and Chemical Bank lit up almost simultaneously. It was 8:45 a.m. on Tuesday, June 21, 1983.
The trader at Salomon Brothers was offering to sell $ 50,000,000 of a new issue of M-S-R Bond Anticipation Notes at 99.50. Salomon was co‑manager of the deal, and Gordon had noticed the tombstone in the Journal that morning (Exhibit 1). Gordon put the Salomon call on hold, picked up the Chemical Bank line, and heard Chemical's trader offer him $ 52,780,000 of Montgomery County, Maryland, notes at 7.04%. Because he expected to receive $ 49,950,000 in cash on July 1, when several notes already in his portfolio matured, Gordon asked both traders whether they would be willing to sell for delivery on that date. When they agreed, he said he would respond to their offers by 9:30 a.m. He had 45 minutes to choose the better investment.
The Municipal Bond Market
Although corporate bonds were more widely followed by the investing public, the municipal bond market was considerably larger. States, local governments, and municipal agencies offered $ 57.3 billion in new bonds in 1982, twice the amount of new corporate issues. “Munis” were distinguished from corporate bonds and U.S. Treasury instruments by the advantageous feature that interest income from municipal bonds was not subject to federal taxation. Consequently, both the individual and the corporate investor could frequently earn a better return by investing in municipal securities, which, although they earned lower rates of interest, produced a tax-free income stream. See Exhibit 2 for the yields of a selection of corporate, Treasury, and municipal bonds.
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Keywords: capital budgeting, internal rate of return, investment analysis, net present value
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