School of Management Studies Finance I (BUS2019S): 2nd Semester 2007

SUGGESTED SOLUTIONS TO TUTORIAL 3

DCF AND BONDS
Chapter 6: Solutions to Questions and Problems
67. PV policy cost = 750/1,09 + 750/1,092 + 850/1,093 + 850/1,094 + 950/1,095 + 950/1,096 = 3
761,74
PV policy benefit = (200 000/1,0659)/1,096 = 3 832,00
Buy the policy
71. EAR = [1+(0,16/365)]365 – 1 = 17,347%
Effective 2-year rate = 1,173472 – 1 = 37,70%
PV@t=1 year hence: R7 500 / 0,3770 = R19 892.26
PV today = R19 892,25 / 1,17347 = R16 951,65
If first payment is 4 years from today, PV today = R19 892,25 / 1,173474 = R10 490,49

74. a. APR = 52(15) = 780%; EAR = 1,1552 – 1 = 143 213,70%

b. 1 = 0,85(1+r); r = 17,65% per week
APR = 52(17,65) = 917,65%; EAR = 1,176552 – 1 = 467 867,68%
c. PVA = R68,92 = R25[ (1 – [1 / (1+r) ]4 ) / r ];
using trial and error or a financial calculator gives r = 16,75% per week
APR = 52(16,75) = 871,00%; EAR = 1,167552 – 1 = 314 210,03%

Chapter 7: Solutions to Questions and Problems

1. The yield to maturity is the required rate of return on a bond expressed as a nominal annual
interest rate. For non-callable bonds, the yield to maturity and required rate of return are
interchangeable terms. Unlike YTM and required return, the coupon rate is not a return used
as the interest rate in bond cash flow valuation, but is a fixed percentage of par over the life of
the bond used to set the coupon payment amount. For the example given, the coupon rate on
the bond is still 10 per cent, and the YTM is 8 per cent.

2. Price and yield move in opposite directions; if interest rates rise, the price of the bond will fall.
This is because the fixed coupon payments determined by the fixed coupon rate are not as
valuable when interest rates rise—hence, the price of the bond decreases.
3. P = R60(PVIFA9,5%,12) + R1000(PVIF9,5%,12) = R755,57
4. P = R1 110 = R115(PVIFAr%,8) + R1000(PVIFr%,8) ; r = YTM = 9,48%
5. P = R750 = C(PVIFA6,5%,13) + R1000(PVIF6,5%,13) ; C = R35,93; coupon rate = 3,59%
12. (1 + r)(1 + 0,09) – 1 = 0,16; r = 6,42%
13. X: P0 = R70(PVIFA6%, 13) + R1 000(PVIF6%, 13) = R1 088,53
P1 = R70(PVIFA6%, 12) + R1 000(PVIF6%, 12) = R1 083,84
P3 = R70(PVIFA6%, 10) + R1 000(PVIF6%, 10) = R1 073,60
P8 = R70(PVIFA6%, 5) + R1 000(PVIF6%, 5) = R1 042,12
P12 = R70(PVIFA6%, 1) + R1 000(PVIF6%, 1) = R1 009,43 ; P13 = R1 000

Y: P0 = R50(PVIFA8%, 13) + R1 000(PVIF8%, 13) = R762,89

P1 = R50(PVIFA8%, 12) + R1 000(PVIF8%, 12) = R773,92
P3 = R50(PVIFA8%, 10) + R1 000(PVIF8%, 10) = R798,70
P8 = R50(PVIFA8%, 5) + R1 000(PVIF8%, 5) = R880,22
P12 = R50(PVIFA8%, 1) + R1 000(PVIF8%, 1) = R972,22 ; P13 = R1 000
All else held equal, the premium over par value for a premium bond declines as maturity is
approached, and the discount from par value for a discount bond declines as maturity is
approached. In both cases, the largest percentage price changes occur at the shortest
maturity lengths.

19. a. Bond price is the present value term when valuing the cash flows from a bond; YTM is the
interest rate used in valuing the cash flows from a bond.
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 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.

21. a. The coupon bonds have a 10% coupon which matches the 10% required return, so
they will sell at par; # of bonds = R10M/R1 000 = 10 000
For the zeroes, Po = R1 000/1,120 = R148,6436; R10M/R148,6436 = 67 275 bonds will be
issued.
b. Coupon bonds: repayment = 10 000 (R1 000) = R10M
Zeroes: repayment = 67 275(R1 000) = R67,275M
c. Coupon bonds: (10 000)(R100)(1 - 0,35) = R650 000 cash outflow
Zeroes: P1 = R1 000/1,119 = R163,51; year 1 interest deduction = R163,51 – R148,64
= R14,86
(67 275)(R14,86)(,35) = R350 000 cash inflow
During the life of the bond, the zero generates cash inflows to the firm in the form of the
interest tax shield of debt.
d. Coupon bonds: NPV = +R10M – R650K(PVIFA6,5%,20) – R10M(PVIF6,5%,20) = R0,00
Zeroes: NPV = +R10M + R10M (1,1 0) x 0,1 x 0,35 x (PVIFA6,5%,1) + R10M(1,11) x 0,1 x
0,35 x
(PVIFA6,5%,2) + … + R10M (1,119) x 0,1 x 0,35 x (PVIFA 6,5%,20) – R67,275M x (PVIFA6,5%,20) =
R0,00

25. PM = R1 000(PVIFA6%,16)(PVIF6%,12) + R1 750(PVIFA6%,12)(PVIF6%,28) + R20 000(PVIF6%,40)

= 1000 x 10,1059 x 0,4970 + 1750 x 8,3838 x 0,1956 + 20 000 x 0,0972
= 5022,6323 + 2869,7747 + 1944,00
= 9836,41
PN = R20 000(PVIF6%,40) = R1 944,44
Test Multiple Choice Questions
QUESTION 2 3 4 5 6 7 8 9
ANSWER c c b c d b d b

1 YEAR 2 YEARS 3 YEARS 4 YEARS 5 YEARS 6 YEARS 7YEARS

RSA 187 NOW FROM FROM FROM FROM FROM FROM FROM MINI CASE SOLUTION
NOW NOW NOW NOW NOW NOW NOW
The coupon amount of R10 000
Cash flow from Coupon [10%] R 0 R 10,000 R 10,000 R 10,000 R 10,000 R 10,000 R 10,000 R 10,000 was the return received for
Cash flow at Maturity R 100,000 holding a 10% bond for the full
Present Value factor AT 12% 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 year. As the yield to maturity
Present Value of each Cash Flow R 8,929 R 7,972 R 7,118 R 6,355 R 5,674 R 5,066 R 49,758 dropped from 12% to 9%,
PURCHASE PRICE R 90,872 investors were prepared to pay
considerably more for the bond,
1 YEAR 2 YEARS 3 YEARS 4 YEARS 5 YEARS 6 YEARS in excess of its nominal value
RSA 187 NOW FROM FROM FROM FROM FROM FROM
NOW NOW NOW NOW NOW NOW which was yielding 1% more
than the market requires.
Cash flow from Coupon [10%] R 0 R 10,000 R 10,000 R 10,000 R 10,000 R 10,000 R 10,000
Cash flow at Maturity #######
Present Value factor AT 12% 1.0000 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963
Present Value of each Cash Flow R 9,174 R 8,417 R 7,722 R 7,084 R 6,499 R 65,589
SELLING PRICE R 104,486

Selling Price R 104,486

Less Cost Price R 90,872
Capital Gain R 13,613
Add Coupon received R 10,000
R 23,613