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 longterm 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.