FIN 612 Managerial Finance

Week Five Assignment

Your assignment for this week is to complete the following questions and problems from Chapter 5. Please submit
your complete assignment in the course room by the due date.

Chapter 5 Questions

(5-2) Short-term interest rates are more volatile than long-term interest rates, so short-term
bond prices are more sensitive to interest rate changes than are long-term bond prices.
Is this statement true or false? Explain.

Short term bonds maybe more sensitive to changes in short-term rates, but long term bonds are more sensitive
generally to changes in rates, with longer term zero coupon bonds being the most sensitive.

The reason is that bonds represent a series of cashflows (interest payments) over time plus a final payment at
maturity. To find the value of the bond, you discount the cashflows by the applicable interest rate using the net
present value formula. Since long bonds have more interest payments over time, there is a bigger change to the value
when interest rates are changed.

The answer to your question is false because short term bonds are valued on short-term rates and longer term bonds
are based on long term rates. Changes in short term rates do not necessarily move in lockstep with changes in long-
term rates. Longer term rates have more of an inflation expectation component.

(5-3) The rate of return on a bond held to its maturity date is called the bonds yield to maturity.
If interest rates in the economy rise after a bond has been issued, what will happen to the
bonds price and to its YTM? Does the length of time to maturity affect the extent to which
a given change in interest rates will affect the bonds price? Why or why not?

If interest rates increase after a bond has been issued, the market value of the bond will decrease. Investors can earn
the higher yields on alternative investments with similar risk, and thus they will only buy previously issued bonds if
their prices have declined to the point where the yields to maturity on the outstanding bonds are equal to the yields
on similar risk alternative investments. Everything else equal, the market prices of bonds with longer terms to
maturity will change more than the prices of bonds with shorter terms to maturity.

(5-4) If you buy a callable bond and interest rates decline, will the value of your bond rise by as
much as it would have risen if the bond had not been callable? Explain.
If interest rate decline in the market, the value of callable bonds will not rise as much as regular bond (bonds with no
call option). The reason is that issuer of bonds has option to redeems the bond any time and when interest rate
decline in the market this is the perfect time for them to redeem the bonds with high interest rate and issue new
bonds with low prevailing market interest rate.

(5-5) A sinking fund can be set up in one of two ways. Discuss the advantages and
disadvantages of each procedure from the viewpoint of both the firm and its bondholders.

(1) The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently
government bonds) and uses the accumulated total to retire the bond issue at maturity.
(2) The trustee uses the annual payments to retire a portion of the issue each year, either calling a given percentage
of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is
cheaper.

Chapter 5 Problems

(5-1) Jackson Corporations bonds have 12 years remaining to maturity. Interest is paid
annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The
bonds have a yield to maturity of 9%. What is the current market price of these bonds?

Recall the formula to find the bond price on the date of a coupon payment:

P = F*r*[1 -(1+i)^-n]/i + C*(1+i)^-n, where

-------------------------------------
F = par value
C = maturity value
r = coupon rate per coupon payment period
i = effective interest rate per coupon payment period
n = number of coupon payments remaining
----------------------

An easy way to derive this formula is to note that the bond price is the present value of all coupons (first term in
formula) + the present value of the maturity value (second term in formula)

------------------

In this problem F = 1000. Since we are not given the maturity value, we can assume that it is the same as the par
value. So, C = 1000.

r = .08
i = .09
n = 12

Therefore, the bond price is 1000*.08 * (1 - 1.09^-12)/.09 + 1000*1.09^-12 = $928.39

(5-2) Wilson Wonderss bonds have 12 years remaining to maturity. Interest is paid annually,
the bonds have a $1,000 par value, and the coupon interest rate is 10%. The bonds sell at a
price of $850. What is their yield to maturity?

100+1000-850/12/1000+850/2 = 112.5/925 = .1216 or 12.16%

(5-5) A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has
a yield of 9%. Assume that the liquidity premium on the corporate bond is 0.5%. What is
the default risk premium on the corporate bond?

YTM-Liquidity-Risk free = default risk premium...

YTM = 9%
Liquidity = 0.5%
Risk free = 6%

9%-0.5%-6% = 2.5%

(5-6) The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2-year
Treasury security yields 6.3%. What is the maturity risk premium for the 2-year security?

r = rfr + ir + Mrp
6.3% = 3% + 3% + Mrp
Mrp = 6.3% - 6% = 0.3%

(5-7) Renfro Rentals has issued bonds that have a 10% coupon rate, payable semiannually.
The bonds mature in 8 years, have a face value of $1,000, and a yield to maturity of 8.5%.
What is the price of the bonds?

Answer:- FV =1,000, PMT= 50, N= 16, R= 4.25%, PV=?
Present Value = $1,085.80

(5-8) Thatcher Corporations bonds will mature in 10 years. The bonds have a face value of
$1,000 and an 8% coupon rate, paid semiannually. The price of the bonds is $1,100.
The bonds are callable in 5 years at a call price of $1,050. What is their yield to maturity?
What is their yield to call?

Given:
TTM = 10 years Face Value = $1,000 C = 8% ($40 semi-annual) Pricecallable = $1,050 TTC = 5 years YTM =
solve
Price = $1,100 YTC = solve
Using Finance Functions: (For Yield to maturity) n = 20 PMT = 40 PV = -1100 FV = 1000
i/2 = 3.3085%
i = 6.617%
YTM = 6.62%
i = solve
Using Finance Functions: (For Yield to call)
n = 9 PMT = 40 PV = -1100 FV = 1050
Note: Instead of having a tenth payment, the ex-dividend assumption accounts for the tenth cashflow
in addition to the final value. i/2 = 3.1924%
i = 6.3849% YTC = 6.38%

(5-10) The Brownstone Corporations bonds have 5 years remaining to maturity.
Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest
rate is 9%.
a. What is the yield to maturity at a current market price of (1) $829 or (2) $1,104?

YTM = 13.978% (829)
YTM = 6.498% (1104)

See: http://www.moneychimp.com/calculator/bond_yield_calculator.htm
and http://www.financeformulas.net/Yield_to_Maturity.html

b. Would you pay $829 for one of these bonds if you thought that the appropriate rate
of interest was 12%that is, if rd = 12%? Explain your answer.
Yes. At a price of $829, the yield to maturity, 14%, is greater than your required rate of return of 12%. If your required
rate of return were 12%, you should be willing to buy the bond at any price below about $890.

(5-14) A bond that matures in 7 years sells for $1,020. The bond has a face value of $1,000 and a
yield to maturity of 10.5883%. The bond pays coupons semiannually. What is the bonds
current yield?

Annual Semi-
annual

0.105883 0.0529415

1 0.9497 $55.00 $52.23 Make a guess for this amount.
2 0.9020 $55.00 $49.61
3 0.8566 $55.00 $47.11
4 0.8136 $55.00 $44.75
5 0.7726 $55.00 $42.50
6 0.7338 $55.00 $40.36
7 0.6969 $55.00 $38.33
8 0.6619 $55.00 $36.40
9 0.6286 $55.00 $34.57
10 0.5970 $55.00 $32.83
11 0.5670 $55.00 $31.18
12 0.5385 $55.00 $29.62
13 0.5114 $55.00 $28.13
14 0.4857 $55.00 $26.71
14 0.4857 $1,000.00 $485.68 Semi Annual
$1,020.01 $55 1020 5.39% 10.78%


(5-18) The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year, and
then 3.5% thereafter. The maturity risk premium is estimated to be 0.0005 (t 1), where
t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury
security?

Nominal interest rate is given as
r = r* + IP + MRP
r* is the risk free rate
DRP = LP = 0. IP = [(3%)1 + (4%)1 + (3.5%)5]/7 = 3.5%. MRP = 0.0005%(7 1) = 0.003%. r12 = 3% +
3.15% + 0.003% = 6.153%.

(5-21) Suppose Hillard Manufacturing sold an issue of bonds with a 10-year maturity, a $1,000
par value, a 10% coupon rate, and semiannual interest payments.
a. Two years after the bonds were issued, the going rate of interest on bonds such as
these fell to 6%. At what price would the bonds sell?

Given:
TTM = 10 years Par = $1,000 Coupon = 10% ($50 payments) r = 6% (after two years)
Using Financial Functions on
n = (10 x 2) - (2 x 2) = 16 i = 6% x .5 = 3
PMT = $100 x .5 = 50 FV = 1000
PV = solve
PV = -$1,251.2220
Bond Price = $1,251.22

b. Suppose that 2 years after the initial offering, the going interest rate had risen to 12%.
At what price would the bonds sell?
Given:
TTM = 10 years Par = $1,000 Coupon = 10% ($50 payments) r = 12% (after two years)
Using Financial Functions on:
n = (10 x 2) - (2 x 2) = 16 i = 12% x .5 = 6
PMT = $100 x .5 = 50 FV = 1000
PV = solve
PV = -$898.9410
Bond Price = $1,251.22
Bond Price = $898.94

c. Suppose that 2 years after the issue date (as in part a) interest rates fell to 6%.
Suppose further that the interest rate remained at 6% for the next 8 years. What
would happen to the price of the bonds over time?
As time progresses, the price/value of the bond will slowly decrease. this table illustrates that:
Using Financial Functions: (Assume i, PMT, and FV remain constant for following figures)
n Price
20 $1,297.55
16 $1,251.22
12 $1,199.08
8 $1,140.39
4 $1,074.34
2 $1,038.27
Therefore, the price decreases over time.