BFM 1014 FUNDAMENTALS OF FINANCE

Trimester 2, 2016-2017

CHAPTER 6: INTEREST RATES AND BOND VALUATION

Concepts Review and Critical Thinking Questions

15. a. What is the relationship between the price of a bond and it’s YTM?

b. Explain why some bonds sells at a premium over par value while other bonds sells at
discount. What do you know about the relationship between the coupon rate and the YTM for
premium bond? What about for discount bonds? For bonds setting at par value?

c. What is the relationship between the current yield and YTM for premium bonds? For
discount bonds? For bond selling at par value?

a. The bond price is the present value when discounting the future cash flows from a bond; YTM
is the interest rate used in discounting the future cash flows (coupon payments and
principal) back to their present values.
b. If the coupon rate is higher than the required return on a bond, the bond will sell at a
premium, since it provides periodic income in the form of coupon payments in excess of
that required by investors on other similar bonds. If the coupon rate is lower than the
required return on a bond, the bond will sell at a discount, since it provides insufficient
coupon payments compared to that required by investors on other similar bonds. For
premium bonds, the coupon rate exceeds the YTM; for discount bonds, the YTM exceeds
the coupon rate, and for bonds selling at par, the YTM is equal to the coupon rate.
c. Current yield is defined as the annual coupon payment divided by the current bond price.
For premium bonds, the current yield exceeds the YTM, for discount bonds the current
yield is less than the YTM, and for bonds selling at par value, the current yield is equal to
the YTM. In all cases, the current yield plus the expected one-period capital gains yield of
the bond must be equal to the required return.

QUESTIONS AND PROBLEM

3. Lycan, Inc. has 6% coupon bond on the market that have 9 years left to maturity. The bond make
annual payments. If the YTM on these bond is 8%, what is the current bond price?

The price of any bond is the PV of the interest payment, plus the PV of the par value. Notice
this problem assumes an annual coupon. The price of the bond will be:

P = $60({1 – [1/(1 + .08)]9} / .08) + $1,000[1 / (1 + .08)9]

P = $875.06

We would like to introduce shorthand notation here. Rather than write (or type, as the case
may be) the entire equation for the PV of a lump sum, or the PVA equation, it is common to
abbreviate the equations as:

PVIFR,t = 1 / (1 + R)t
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 which stands for Present Value Interest Factor

PVIFAR,t = ({1 – [1/(1 + R)]t } / R)

which stands for Present Value Interest Factor of an Annuity

These abbreviations are shorthand notation for the equations in which the interest rate and
the number of periods are substituted into the equation and solved. We will use this shorthand
notation in the remainder of the solutions key. The bond price equation for this problem would
be:

P = $60(PVIFA8%,9) + $1,000(PVIF8%,9)
P = $875.06

4. Timberlake-Jackson Wardrobe Co. has 7% coupon bonds on the market with nine years left to
maturity. The bonds make annual payments. If the bond currently sells for $1,038.50, what is
its YTM?

Here, we need to find the YTM of a bond. The equation for the bond price is:

P = $1,038.50 = $70(PVIFAR%,9) + $1,000(PVIFR%,9)

Notice the equation cannot be solved directly for R. Using a spreadsheet, a financial calculator,
or trial and error, we find:

R = YTM = 6.42%

If you are using trial and error to find the YTM of the bond, you might be wondering how to
pick an interest rate to start the process. First, we know the YTM has to be lower than the
coupon rate since the bond is a premium bond. That still leaves a lot of interest rates to check.
One way to get a starting point is to use the following equation, which will give you an
approximation of the YTM:

Approximate YTM = [Annual interest payment + (Par value – Price) / Years to maturity] /
[(Price + Par value) / 2]

Solving for this problem, we get:

Approximate YTM = [$70 + (–$38.50 / 9)] / [($1,038.50 + 1,000) / 2]

Approximate YTM = .0645, or 6.45%

This is not the exact YTM, but it is close, and it will give you a place to start.

5. Merton Enterprises has bonds on the market making annual payment, within 12 years to
maturity, and selling for $963. At this price, the bonds yield 7.5%. What must the coupon rate
be on Merton’s bonds?

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 Here we need to find the coupon rate of the bond. All we need to do is to set up the bond
pricing equation and solve for the coupon payment as follows:

P = $963 = C(PVIFA7.5%,12) + $1,000(PVIF7.5%,12)

Solving for the coupon payment, we get:

C = $70.22

The coupon payment is the coupon rate times par value. Using this relationship, we get:

Coupon rate = $70.22 / $1,000

Coupon rate = .0702, or 7.02%

15. Bond X is a premium bond making annual payments. The bond pays an 9% coupon, has a YTM
of 7%, and has 13 years to maturity. Bond Y is a discount bond making annual payments. This
bond pays a 7% coupon, has YTM of 9% and also has 13 years to maturity.

What are the prices if these bond today?

If interest rates remains unchanged, what do you expect the prices of these bonds to be in one
year? In 3 years? In 8 years? In 12 years? In 13 years? What is going on here? Illustrate your
answers by graphing bond prices versus time to maturity.

Here, we are finding the price of annual coupon bonds for various maturity lengths. The bond
price equation is:

P = C(PVIFAR%,t) + $1,000(PVIFR%,t)

X: P0 = $90(PVIFA7%,13) + $1,000(PVIF7%,13) = $1,167.15

P1 = $90(PVIFA7%,12) + $1,000(PVIF7%,12) = $1,158.85
P3 = $90(PVIFA7%,10) + $1,000(PVIF7%,10) = $1,140.47
P8 = $90(PVIFA7%,5) + $1,000(PVIF7%,5) = $1,082.00
P12 = $90(PVIFA7%,1) + $1,000(PVIF7%,1) =
$1,018.69
P13 = $1,000
Y: P0 = $70(PVIFA9%,13) + $1,000(PVIF9%,13) = $850.26
P1 = $70(PVIFA9%,12) + $1,000(PVIF9%,12) = $856.79
P3 = $70(PVIFA9%,10) + $1,000(PVIF9%,10) = $871.65
P8 = $70(PVIFA9%,5) + $1,000(PVIF9%,5) = $922.21
P12 = $70(PVIFA9%,1) + $1,000(PVIF9%,1) =
$981.65
P13 = $1,000

All else held equal, the premium over par value for a premium bond declines as maturity
approaches, and the discount from par value for a discount bond declines as maturity approaches.
This is called “pull to par.” In both cases, the largest percentage price changes occur at the
shortest maturity lengths.

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Also, notice that the price of each bond when no time is left to maturity is the par value, even
though the purchaser would receive the par value plus the coupon payment immediately. This is
because we calculate the clean price of the bond.

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 Maturity and Bond Price
$1,300

$1,200

$1,100
Bond Price

$1,000
Bond X
Bond Y

$900

$800

$700
13 12 11 10 9 8 7 6 5 4 3 2 1 0
Maturity (Years)