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60 Ansichten16 SeitenFINANCIAL STATEMENT ANALYSIS

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FINANCIAL STATEMENT ANALYSIS

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60 Ansichten16 SeitenFINANCIAL STATEMENT ANALYSIS

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SOLUTIONS MANUAL

CHAPTER 12

PRINCIPLES OF BOND VALUATION AND INVESTMENT

Answers to Text Discussion Questions

1. Why are bonds not necessarily a conservative investment?

12-1. Since bond prices are sensitive to interest rate changes, capital gains or losses are

possible even though interest is paid regularly.

2. How can the market price of a bond be described in terms of present value?

12-2. The price of a bond is the present value of the annuity created by the interest

payments plus the present value of the lump sum of principal returned at maturity.

3. Why does a bond price change when interest rates change?

12-3. Since the bond has a fixed return (the interest promised) based on the bond

contract, the market price of a bond changes to reflect changes in market interest

rates. A bond's price changes to indicate the present value of future cash return,

both interest and principal based on market interest rates (discount factors).

Floating rate bonds are an exception to this principle.

4. Why is current yield not a good indicator of bond returns? (Relate your answer to

maturity considerations.)

12-4. The current yield does not consider the length of time to maturity. A dollar

received this year is worth more than dollars received in future years.

5. Describe how yield to maturity is the same concept as the internal rate of return (or

true yield) on an investment.

12-5. Yield to maturity is the same concept as internal rate of return or true yield

because it is the interest rate (i) at which you can discount the future coupon

payments (Ct) and maturity value (Pn) to arrive at a known current value (V) of

the bond.

6. What is the significance of the yield-to-call calculation?

12-6. If a bond is callable, the yield to call calculation shows what the yield for that

time period would be as compared to yield to maturity (which you may never get

to) or some other length of time.

12-1

7. What is the bond reinvestment assumption? Is this necessarily

correct?

12-7. It is assumed that funds are reinvested at the yield from the investment. This is not

necessarily the case. Reinvestment may take place at a higher or lower rate (as

will be discussed in the next chapter).

8. What is the meaning of term structure of interest rates?

12-8. The term structure of interest rates depicts the relationship between maturity and

interest rates. It is sometimes called a yield curve because yields on existing

securities, having maturities anywhere from three months to 30 years, are plotted

on a graph to develop the curve.

9. What does an ascending term structure pattern tend to indicate?

12-9. When the term structure is in an ascending posture (short-term rates are lower

than long-term rates), it is a general signal that interest rates will rise in the future.

10. Explain the general meaning of the expectations hypothesis as it relates to the term

structure of interest rates.

12-10. The hypothesis is that any long-term rate is an average of the expectation of future

short-term rates over the applicable time horizon. Thus, if lenders expect shortterm rates to be continually increasing in the future, they will demand higher

long-term rates. Conversely, if they anticipate short-term rates to be declining,

they will accept lower long-term rates.

11. Explain the liquidity preference theory as it relates to the term structure of interest

rates.

12-11. The shape of the term structure of interest rates tends to be upward sloping more

than any other pattern. This reflects recognition of the fact that long-term maturity

obligations are subject to greater price change movements when interest rates

change. Because of the increased risk of holding longer-term maturities, investors

demand a higher return to hold long-term securities relative to short-term

securities. This is called the liquidity preference theory of interest rates. Since

short-term securities are more easily turned into cash without the risk of large

price changes, investors will pay a higher price and receive a lower yield.

12-2

12. How might the market segmentation theory help to explain why shortterm rates on government securities increase when bank loan demand

becomes high?

12-12. When bank loan demand becomes high, banks are likely to partially withdraw

from investments in government securities. Since banks are an important part of

the short-term side of the market, their reduced demand will likely drive up shortterm rates on government securities.

13. Under what circumstances would the yield spread on different classes of debt

obligations tend to be largest?

12-13. The yield spread represents the difference in returns for different classes of bonds

based on ratings. The yield spread tends to be largest when there is a low degree of

confidence in the economy as in the early phases of a recession as investors attempt to

shift out of low grade securities into strong instruments.

14. List the six principles associated with bond-pricing relationships.

12-14. 1.

2.

3.

4.

5.

6.

Prices of long-term bonds are more sensitive to a change in yields to

maturity than short-term bonds.

Bond price sensitivity increases at a decreasing rate as maturity increases.

Bond prices are more sensitive to a decline in market yield to maturity

than to a rise in market yield to maturity.

Prices of low coupon bonds are more sensitive to a change in yields to

maturity than high coupon bonds.

Bond prices are more sensitive when yields to maturity are low than when

yields to maturity are high.

12-15. Borrowing to purchase bonds requires relatively little margin. For government

securities, the amount be put down may be as little as 5 percent and for corporate

bonds, it may be 30 percent. The leverage available can affect returns

dramatically. Investors may use margin to enhance percentage returns if they

expect interest rates to go down, but margin can also cause large percentage losses

if they are wrong and interest rates go up.

12-3

16. Explain the benefits derived from investing in deep discount bonds.

12-16. Deep discount bonds have almost no change of being called away even if prices

go up because the value is already far removed from par. Secondly, deep discount

bonds offer the opportunity for higher price increases than high coupon bonds if

interest rates decline.

17. What is a bond swap investment strategy? Explain how it might relate to tax

planning.

12-17. The term "Swap" refers to the procedure of selling out of a given bond position

and immediately buying into another one with similar attributes in an attempt to

improve overall portfolio return or performance.

For tax planning purposes, you might sell a bond on which you have a large loss

and take a reduction against other income. You then take the proceeds from the

sale and reinvest in a bond of equal risk, and you will have increased your total

cash returns because of tax benefits.

PROBLEMS

Bond price

1. Given a 10-year bond that sold for $1,000 with a 13 percent coupon rate, what would

be the price of the bond if interest rates in the marketplace on similar bonds are now 10

percent? Interest is paid semiannually. Assume a 10-year time period.

12-1. PV of $65 semiannually for n = 20 and i = 5%

(Table 12-1 or Appendix D)

$1, 000 .377

12-4

377.00

$1,187.03

Bond price

2. Given a 15-year bond that sold for $1,000 with a 9 percent coupon rate, what would be

the price of the bond if interest rates in the marketplace on similar bonds are now 12

percent? Interest is paid semiannually. Assume a 15-year time period.

12-2. PV of $45 semiannually for n = 30 and i = 6%

(Table 12-1 or Appendix D)

$1, 000 .174

174.00

$793.43

Bond price

3. Given the facts in problem 2, what would be the price if interest rates go down to 8

percent? (Once again, do a semiannual analysis.)

12-3. PV of $45 semiannually for n = 30 and i = 4%

(Table 12-1 or Appendix D)

$1, 000 .308

308.00

$1, 086.14

4. Using Table 123, on page 317 determine the price of a

a. 10 percent coupon rate bond, with 20 years to maturity and a 14 percent yield to

maturity.

b. 12 percent coupon rate bond with 10 years to maturity and an 8 percent yield to

maturity.

12-4. a)

12-5

5. Using Table 123, on page 317

Assume you bought a bond with a 10 percent coupon rate with 20 years to maturity at a

yield to maturity of 14 percent. Further assume 10 years later the yield to maturity is 8

percent.

Determine the price of the bond that you initially paid and the bond price with 10

years remaining to maturity. Also, compute the dollar and percentage profit related to the

bond over the 10-year holding period.

12-5. 20 years, 14 percent 73.34% $1,000 = $ 733.40

10 years, 8 percent 113.50% $1,000 = $1,135.00

Dollar Profit

$1,135.00

733.40

Purchase price

$ 401.60

Dollar profit

Percent Profit

Dollar profit $401.60

54.76%

Purchase price $733.40

Current yield

6. What is the current yield of an 8 percent coupon rate bond priced at $877.60?

12.6.

Yield to maturity

7. What is the yield to maturity for the data in problem 6? Assume there are 10 years left

to maturity. It is a $1,000 par value bond. Use the trial-and-error approach with annual

analysis. [Hint: Because the bond is trading for less than par value, you can assume the

interest rate (i) for which you are solving is greater than the coupon rate of 8 percent.]

12.7.

Since the interest rate must be greater than 8%, we will try 9% as a first

approximation.

PV of $80 annually for n = 10, i = 9%

(Table 12-1 or Appendix D)

12-6

12-7

422.00

$935.44

At a 9% discount rate, the answer is $935.44. This is higher than our desired value of

$877.60. In order to bring the value down, we will use a higher interest rate. Lets try

10%.

PV of $80 annually for n = 10, i = 10%

(Table 12-1 or Appendix D)

$1, 000 .386

386.00

$877.60

A 10% discount rate provides the bond price of $877.60. Ten percent is the

yield to maturity.

Yield to maturity

8. What is the yield to maturity for a 10 percent coupon rate bond priced at $1,090.90?

Assume there are 20 years left to maturity. It is a $1,000 par value bond. Use the trialand-error approach with annual analysis. (Hint: Because the bond is trading at a price

above par value, first decide whether your initial calculation should be at an interest rate

above or below the coupon rate.)

12-8. With the bond trading above par value, the discount rate must be below the

coupon rate of 10%. Lets try 9%.

PV of $100 annually for n = 20, i = 9%

(Table 12-1 or Appendix D)

$1, 000 .178

178.00

$1, 090.90

Since 9% provides the desired bond value of $1,090.90, it is the yield to maturity.

Comparison of yields

9. What is the current yield in problem 8? Why is it slightly higher than the yield to

maturity?

12-9. $100/$1,090.90 = 9.17%

It is higher than yield to maturity because it does not take into consideration the

fact that the bond price will decline from $1,090.90 to $1,000 over the next 20

years. This factor lowers the yield to maturity.

12-8

10. A 15-year, 7 percent coupon rate bond is selling for $839.27.

a. What is the current yield?

b. What is the yield to maturity using the trial-and-error approach with annual

calculations?

c. Why is the current yield higher/lower than the yield to maturity?

12-10. a) Current Yield

$70

$8.34%

$839.27

b) Since the bond is trading below par value, the yield to maturity (interest rate)

must be above 7 percent. Lets try 8 percent.

PV of $80 annually for n = 15, i = 8%

(Table 12-1 or Appendix D)

$1, 000 .315

$315.00

$914.13

At an 8% discount rate, the answer is $914.13. This is higher than our desired

value of $839.27. In order to bring the value down, we must use a higher interest

rate. Lets try 9%.

PV of $80 annually for n = 15, i = 9%

(Table 12-1 or Appendix D)

$1, 000 .275

$275.00

$839.27

A 9% discount rate provides the bond price $839.27. 9% is the yield to maturity.

12-9

11. What is the approximate yield to maturity of a 14 percent coupon rate, $1,000 par

value bond priced at $1,160 if it has 16 years to maturity? Use Formula 122 on page

320.

12-11.

y'

Number of periods to Maturit y (n)

(0.6) Market Value (V) + (0.4) Par Value(Pn )

Coupon payment (C t )

$1, 000 $1,160

16

y'

(0.6)$1,160 + (0.4)$1, 000

$160

$140

16

$696 $400

$140 $10 $130

11.86%

$1, 096

$1, 096

$140

Yield to call

12. a. Using the facts given in problem 11, what would be the yield to call if the call can

be made in four years at a price of $1,080? Use Formula 123 on page 321.

b. Explain why the answer is lower in part a than in problem 11.

c. Given a call value of $1,080 in four years, is it likely that the bond price would actually

get to $1,160?

12-12. a)

Number of periods to Call (n c )

(0.6) Market Value (V) + (0.4) Call Price (Pc )

Coupon payment (C t )

y'

$1, 080 $1,160

4

y'

(0.6)$1,160 + (0.4)$1, 080

$80

$140

4

$696 $432

$140 $20 $120

10.64%

$1,128

$1,128

$140

12-10

b) Because the bond is callable at $1,080 in four years, the investor must consider

the $80 loss in value over four years from $1,160 to $1,080 ($20 per year). This

substantially reduces yield.

In problem 11, there is also a loss in value from $1,160 to $1,000, but it takes

place over 16 years (only $10 per year). The normal amortization of the premium

over the life of the bond has less of a negative effect on yield.

c) No. The threat of the call will likely keep the price closer to $1,080 (though

with four years to call, a littler higher value than $1,080 may be possible if the

yield on the bond is well above market rates).

Anticipated realized yield

13. a. Using the facts given in problem 11, what would be the anticipated realized yield if

the forecast is that the bond can be sold in three years for $1,280? Use Formula 124 on

page 322. Continue to assume the bond has a 14 percent coupon rate ($140) and a current

price of $1,160.

b. Now break down the anticipated realized yield between current yield and capital

appreciation. (Hint: Compute current yield and subtract this from anticipated realized

yield to determine capital appreciation.)

12-13. a)

Number of periods to realization (n r )

(0.6) Market Value (V) + (0.4) Realized Price (Pr )

Coupon payment (C t )

y 'r

$1, 280 $1,160

3

y 'r

(0.6) ($1,160) + (0.4) ($1, 280)

$120

$140

3

$696 $512

$140 $40 $180

14.90%

$1, 208

$1, 208

$140

12.07%

Price

$1,160

b)

Capital appreciation = Anticipated realized yield Current yield

14.90% 12.07% 2.83%

Current yield =

12-11

14. An investor places $800,000 in 30-year bonds (12 percent coupon rate), and interest

rates decline by 3 percent. Use Table 124 on page 327 to determine the current value of

the portfolio.

$ 800, 000

30.96%

12-14.

$ 247, 680

$ 800, 000

247, 680

$1, 047, 680

Initial value

(Table12 - 4 for12%,30 years,

Gain

Initial value

Gain

Total value

15. Use Table 124 on page 327 to describe the worst possible scenario for a $1,000

bond based on yield change, years to maturity, and coupon rate. What would be the price

of the bond?

12-15. The worst possible care would be for yield to rise by the maximum amount in the

table (+3%), for the longest maturity (30 years), at the lowest coupon rate (6%).

A decline of 30.82 percent would take place and the new price of the bond

would be $691.80.

$ 1, 000

69.18%

$ 691.80

Par value

(100% 30.82%)

New bond price

12-12

Expectations hypothesis

16. The following pattern for one-year Treasury bills is expected over the next four

years:

Year 1 -5%

Year 2 -7%

Year 3-10%

Year 4-11%

a. What return would be necessary to induce an investor to buy a two-year security?

b. What return would be necessary to induce an investor to buy a three-year security?

c. What return would be necessary to induce an investor to buy a four-year security?

d. Diagram the term structure of interest rates for years 1 through 4.

b) 3-year security (5% + 7% + 10%)/3 = 7.33%

c) 4-year security (5% + 7% + 10% + 11%)/4 = 8.25%

d) Yield

Maturity

12-13

Margin purchase

17. a. Assume an investor purchases a 10-year, $1,000 bond with a coupon rate of 12

percent. The market rate almost immediately falls to 9 percent. What would be the

percentage return on the investment if the buyer borrowed part of the funds with a 25

percent margin requirement? Assume the interest payments on the bond cover the interest

expense on the borrowed funds. (You can use Table 123 in this problem to determine the

new value of the bond.)

b. Assume the same bond in part a is purchased with 25 percent margin, but market rates

go up to 14 percent from 12 percent instead of going down to 9 percent. You can once

again use Table 123 on page 317 to determine the price of the bond. What is the

percentage loss on the cash investment?

12-17. a) The new bond price is $1,195.10 (Table 12-3 for 10 periods with a 12 percent

coupon rate and a 9 percent yield to maturity)

Original bond price

$1,000.00

Increase in value

$ 195.10

Return on investment

Return

$195.10

78.04%

Investment $250.00

$894.10

(Table 12-3 for 10 periods with a 12 percent

coupon rate and a 14 percent yield to maturity)

Original bond price

$1,000.00

Decrease in value

$ 105.90

Loss on investment

Loss

$105.90

(42.36)%

Investment $250.00

12-14

18. Assume an investor is trying to choose between purchasing a deep discount bond or a

par value bond. The deep discount bond pays 6 percent interest, has 20 years to maturity,

and is currently trading at $656.80 with a 10 percent yield to maturity. It is callable at

$1,050.

The second bond is selling at its par value of $1,000. It pays 12 percent interest and has

20 years to maturity. Its yield to maturity is also 12 percent. The bond is callable at

$1,080.

a. If the yield to maturity on the deep discount bond goes down by 2 percent to 8 percent,

what will the new price of the bond be? Do semiannual analysis.

b. If the yield to maturity on the par value bond goes down by 2 percent to 10 percent,

what will the new price of the bond be? Do semiannual analysis.

c. Based on the facts in the problem and your answers to parts a and which bond appears

to be the better purchase? (Consider the call feature as well as capital appreciation.)

12-18. a) PV of $30 semiannually for n = 40 and i = 4%

(Table 12-1 or Appendix D)

(Table 12-2 or Appendix C)

$1, 000 .208 208.00

$801.79

b) PV of $60 semiannually for n = 40 and i = 5%

(Table 12-1 or Appendix D)

$1, 000 .142

Bond price

142.00

$1,171.60

c) The deep discount bond is probably the better purchase because a call price of

$1,050 will have no influence on the increase in the bond value. The par value

bond is callable to $1,080 and this may hold down the potential price appreciation

of the bond.

Even if both bonds increase in value as indicated in parts (a) and (b), the deep

discount bond will have the larger percentage gain.

12-15

New value (Part A)

$801.79

Gain in value $144.99

Gain in value $144.99

Original value $656.80

Return = $144.99/$656.80 = 22.08%

Par Value Bond

New value (Part B)

$1,171.60

Gain in value $ 171.60

Gain in value $ 171.60 = 17.16%

Original value $1,000.00

Return = $171.60/$1,000 = 17.16%

Solution to Investment Advisor Problem

a. Robert Walker failed to follow rule 5, which states that low-coupon rate bonds are

more sensitive to interest rate changes than high coupon rate bonds (this same

principle can be expressed through rule 6 as well in terms of yield to maturity.

Low coupon U.S. government bonds have the greatest price sensitivity because

there is no credit risk, and they are exclusively influenced by interest rates.

Conversely, high coupon rate bonds (so called junk bonds if their rating is below

the first four rating categories are influenced by a multitude of factors. These

include earnings outlook, competitive conditions, potential lawsuits, etc. They

may well be more influenced by these factors than interest rate changes.

This

generally makes them a poor candidate for interest rate plays.

b.

He was selling bonds for a profit before the required 12-month holding period to

qualify for a long-term capital gain favorable tax rate. That maximum rate is 15

percent as opposed to 35 percent for short-term capital gains.

12-16

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