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of Bonds

CHAPTER ORIENTATION

This chapter introduces the concepts that underlie asset valuation. We are specifically

concerned with bonds. We also look at the concept of the bondholder's expected rate of

return on an investment.

CHAPTER OUTLINE

I. Types of bonds

A. Debentures: unsecured long-term debt.

B. Subordinated debentures: bonds that have a lower claim on assets in the event

of liquidation than do other senior debt holders.

C. Mortgage bonds: bonds secured by a lien on specific assets of the firm, such

as real estate.

D. Eurobonds: bonds issued in a country different from the one in whose

currency the bond is denominated; for instance, a bond issued in Europe or

Asia that pays interest and principal in U.S. dollars.

E. Zero and low coupon bonds allow the issuing firm to issue bonds at a

substantial discount from their $1,000 face value with a zero or very low

coupon.

1. The disadvantages are, when the bond matures, the issuing firm will

face an extremely large nondeductible cash outflow much greater than

the cash inflow they experienced when the bonds were first issued.

2. Discount bonds are not callable and can be retired only at maturity.

3. On the other hand, annual cash outflows associated with interest

payments do not occur with zero coupon bonds.

F. Junk bonds: bonds rated BB or below.

226

II. Terminology and characteristics of bonds

predetermined, fixed amount of interest each year until maturity. At maturity,

the principal will be paid to the bondholder.

firm's assets before the preferred and common stockholders. Also,

bondholders must be paid interest due them before dividends can be

distributed to the stockholders.

C. A bond's par value is the amount that will be repaid by the firm when the bond

matures, usually $1,000.

D. The contractual agreement of the bond specifies a coupon interest rate that is

expressed either as a percent of the par value or as a flat amount of interest

which the borrowing firm promises to pay the bondholder each year. For

example: A $1,000 par value bond specifying a coupon interest rate of nine

percent is equivalent to an annual interest payment of $90.

E. The bond has a maturity date, at which time the borrowing firm is committed

to repay the loan principal.

predetermined number of the firm’s shares of common stock.

G. A bond is callable or redeemable when it provides the firm with the right to

pay off the bond at some time before its maturity date. These bonds frequently

have a call protection period which prevents the firm from calling the bond for

a pre-specified time period.

H. An indenture (or trust deed) is the legal agreement between the firm issuing

the bonds and the bond trustee who represents the bondholders. It provides

the specific terms of the bond agreement such as the rights and responsibilities

of both parties.

I. Bond ratings

1. Bond ratings are simply judgments about the future risk potential of

the bond in question. Bond ratings are extremely important in that a

firm’s bond rating tells much about the cost of funds and the firm’s

access to the debt market.

and Fitch Investor Services.

227

III. Definitions of value

A. Book value is the value of an asset shown on a firm's balance sheet which is

determined by its historical cost rather than its current worth.

B. Liquidation value is the amount that could be realized if an asset is sold

individually and not as part of a going concern.

C. Market value is the observed value of an asset in the marketplace where

buyers and sellers negotiate an acceptable price for the asset.

D. Intrinsic value is the value based upon the expected cash flows from the

investment, the riskiness of the asset, and the investor's required rate of return.

It is the value in the eyes of the investor and is the same as the present value

of expected future cash flows to be received from the investment.

IV. Valuation: An Overview

A. Value is a function of three elements:

1. The amount and timing of the asset's expected cash flow

2. The riskiness of these cash flows

3. The investors' required rate of return for undertaking the investment

B. Expected cash flows are used in measuring the returns from an investment.

The value of an asset is found by computing the present value of all the future cash

flows expected to be received from the asset. Expressed as a general present value

equation, the value of an asset is found as follows:

$C1 $C 2 $Cn

V = + +L+

(1+ k ) (1+ k ) (1+ k )

1 2 n

V = the intrinsic value or present value of an asset

producing expected future cash flows, Ct, in

years 1 through N

k = the investor's required rate of return

n = the number of periods

228

VI. Bond Valuation

A. The value of a bond is simply the present value of the future interest payments

and maturity value discounted at the bondholder's required rate of return. This

may be expressed as:

$I 1 $I 2 $In $M

Vb = + + L+ +

(1+kb ) (1+kb ) (1+kb ) (1+kb )

1 2 n n

payment

kb = the required rate of return for the bondholder

n = the number of periods to maturity

In other words, we are discounting the expected future cash flows to the

present at the appropriate discount rate (required rate of return).

B. If interest payments are received semiannually (as with most bonds) the

valuation equation becomes:

$ I1 / 2 $I 2 / 2 $ I 2n / 2 $M

Vb = 1

+ 2

+L+ 2n

+ 2n

kb kb kb kb

1 + 1 + 1 + 1 +

2 2 2 2

VII. Bond Yields

A. Yield to maturity

1. The yield to maturity is the rate of return the investor will earn if the

bond is held to maturity, provided, of course, that the company issuing

the bond does not default on the payments.

2 We compute the yield to maturity by finding the discount rate that gets

the present value of the future interest payments and principal payment

just equal to the bond's current market price.

B. Current yield

1. The current yield on a bond is the ratio of the annual interest payment o the

bond’s current market price.

2 The current yield is not an accurate measure of the bondholder’s expected rate

of return from holding the bond to maturity.

229

VIII. Bond Value: Three Important Relationships

A. First relationship

A decrease in interest rates (required rates of return) will cause the value of a

bond to increase; an interest rate increase will cause a decrease in value. The

change in value caused by changing interest rates is called interest rate risk.

B. Second relationship

1. If the bondholder's required rate of return (current interest rate) equals

the coupon interest rate, the bond will sell at par, or maturity value.

2. If the current interest rate exceeds the bond's coupon rate, the bond

will sell below par value or at a "discount."

3. If the current interest rate is less than the bond's coupon rate, the bond

will sell above par value or at a "premium."

C. Third relationship

A bondholder owning a long-term bond is exposed to greater interest rate risk

than when owning a short-term bond.

ANSWERS TO

END-OF-CHAPTER QUESTIONS

7-1. The term debenture applies to any unsecured long-term debt. Because these bonds are

unsecured, the earning ability of the issuing corporation is of great concern to the

bondholder. They are also viewed as being more risky than secured bonds and, as a

result, must provide investors with a higher yield than secured bonds provide. Often

the issuing firm attempts to provide some protection to the holder through the

prohibition of any additional encumbrance of assets. This prohibits the future

issuance of secured long-term debt that would further tie up the firm's assets and

leave the bondholders less protected. To the issuing firm, the major advantage of

debentures is that no property has to be secured by them. This allows the firm to issue

debt and still preserve some future borrowing power.

A mortgage bond is a bond secured by a lien on real property. Typically, the value of

the real property is greater than that of the mortgage bonds issued. This provides the

mortgage bondholders with a margin of safety in the event the market value of the

secured property declines. In the case of foreclosure, the trustees have the power to

sell the secured property and use the proceeds to pay the bondholders. In the event

that the proceeds from this sale do not cover the bonds, the bondholders become

general creditors, similar to debenture bondholders, for the unpaid portion of the debt.

230

7-2. a. Eurobonds are not so much a different type of security as they are securities,

in this case bonds, issued in a country different from the one in whose

currency the bond is denominated. For example, a bond that is issued in

Europe or in Asia by an American company and that pays interest and

principal to the lender in U.S. dollars would be considered a Eurobond. Thus,

even if the bond is not issued in Europe, it merely needs to be sold in a

country different from the one in whose currency it is denominated to be

considered a Eurobond.

b. Zero and very low coupon bonds allow the issuing firm to issue bonds at a

substantial discount from their $1,000 face value with a zero or very low

coupon. The investor receives a large part (or all on the zero coupon bond) of

the return from the appreciation of the bond at maturity.

c. Junk bonds refer to any bond with a rating of BB or below. The major

participants in this market are new firms that do not have an established

record of performance. Many junk bonds have been issued to finance

corporate buyouts.

7-3. In the case of insolvency, claims of debt in general, including bonds, are honored

before those of both common stock and preferred stock. However, different types of

debt may also have a hierarchy among themselves as to the order of their claim on

assets.

Bonds also have a claim on income that comes ahead of common and preferred stock.

If interest on bonds is not paid, the bond trustees can classify the firm insolvent and

force it into bankruptcy. Thus, the bondholder's claim on income is more likely to be

honored than that of common and preferred stockholders, whose dividends are paid at

the discretion of the firm's management.

7-4. a. The par value is the amount stated on the face of the bond. This value does

not change and, therefore, is completely independent of the market value.

However, the market value may change with changing economic conditions

and changes within the firm.

b. The coupon interest rate is the rate of interest that is contractually specified in

the bond indenture. As such, this rate is constant throughout the life of the

bond. The coupon interest rate indicates to the investor the amount of interest

to be received in each payment period. On the other hand, the investor's

required interest rate is equivalent to the bond’s current yield to maturity,

which changes with the bond's changing market price. This rate may be

altered as economic conditions change and/or the investor's attitude toward

the risk-return trade-off is altered.

7-5. Ratings involve a judgment about the future risk potential of the bond. Although they

deal with expectations, several historical factors seem to play a significant role in

their determination. Bond ratings are favorably affected by (1) a greater reliance on

equity, and not debt, in financing the firm, (2) profitable operations, (3) a low

variability in past earnings, (4) large firm size, and (5) little use of subordinated debt.

In turn, the rating a bond receives affects the rate of return demanded on the bond by

the investors. The poorer the bond rating, the higher the rate of return demanded in

the capital markets.

231

For the financial manager, bond ratings are extremely important. They provide an

indicator of default risk that in turn affects the rate of return that must be paid on

borrowed funds.

7-6. Book value is the asset's historical value and is represented on the balance sheet as

cost minus depreciation. Liquidation value is the dollar sum that could be realized if

the asset were sold individually and not as part of a going concern. Market value is

the observed value for an asset in the marketplace where buyers and sellers negotiate

a mutually acceptable price. Intrinsic value is the present value of the asset's

expected future cash flows discounted at an appropriate discount rate.

7-7. The intrinsic value of a security is equal to the present value of cash flows to be

received by the investor. Hence, the terms value and present value are synonymous.

7-8. The first two factors affecting asset value (the asset characteristics) are the asset's

expected returns and the riskiness of these returns. The third consideration is the

investor's required rate of return. The required rate of return reflects the investor's

risk-return preference.

7-9. The relationship is inverse. As the required rate of return increases, the value of the

security decreases, and a decrease in the required rate of return results in a price

increase.

7-10. The expected rate of return is the rate of return that may be expected from purchasing

a security at the prevailing market price. Thus, the expected rate of return is the rate

that equates future cash flows with the actual selling price of the security in the

market, which is also called the yield to maturity.

232

SOLUTIONS TO

END-OF-CHAPTER PROBLEMS

7-1.

20

$70 $1,000

a. $875 = ∑

t =1 (1 + k b ) t

+

(1 + k b ) 20

20 N

875 PV

70 PMT

1000 FV

CPT I /Y → ANSWER 8.30%

20

$70 $1,000

b. Value (Vb) = ∑

t =1 (1 + .10)20

+

(1 + .10)20

= $744.59

20 N

10 I/Y

70 PMT

1000 FV

CPT PV → ANSWER -744.59

14

$70 $1,000

7-2. Value (Vb) = ∑

t =1 (1 + .10)14

+

(1 + .10)14

14 N

10 I/Y

70 PMT

1000 FV

CPT PV → ANSWER -779.00

233

7-3.

10

$60 $1,000

a. Value (Vb) = ∑

t =1 (1 + .08)10

+

(1 + .08)10

= $865.80

10 N

8 I/Y

60 PMT

1000 FV

CPT PV → ANSWER -865.80

$1,060

b. $875 =

(1 + k b )1

1 N

875 PV

0 PMT

1060 FV

CPT I /Y → ANSWER 22.43%

16

$50 $1,000

Value (Vb) = ∑

t =1 (1.04)t

+

(1.04)16

16 N

4 I/Y

50 PMT

1000 FV

CPT PV → ANSWER -1116.52

234

If interest is paid annually:

8

$100 $1,000

Value (Vb) = ∑

t =1 (1.08)t

+

(1.08)8

8 N

8 I/Y

100 PMT

1000 FV

CPT PV → ANSWER 1114.93

7-5.

a. Series A:

12

$85 $1,000

Value (Vb) = ∑

t =1 (1.05)12

+

(1.05)12

12

$85 $1,000

Value (Vb) = ∑

t =1 (1.08)12

+

(1.08)12

12

$85 $1,000

Value (Vb) = ∑

t =1 (1.12)12

+

(1.12)12

12 N

I/Y = 5% 8% 12%

85 PMT

1000 FV

CPT PV →ANSWER 1,310.21 1,037.68 783.20

235

Series B

1

$85 $1,000

Value (Vb) = ∑

t =1 (1.05)1

+

(1.05)1

1

$85 $1,000

Value (Vb) = ∑

t =1 (1.08)1

+

(1.08)1

1

$85 $1,000

Value (Vb) = ∑

t =1 (1.12)1

+

(1.12)1

1 N

I/Y = 5% 8% 12%

85 PMT

1000 FV

CPT PV →ANSWER 1,033.33 1,004.63 968.75

b. Longer-term bondholders are locked into a particular interest rate for a longer

period of time and are therefore exposed to more interest rate risk

20

$40 $1,000

7-6. $900 = ∑ (1 + k b /2) t

+

(1 + k b /2) 20

t =1

20 N

900 +/- PV

40 PMT

1000 FV

CPT I/Y → ANSWER 4.79 semiannual rate

The rate is equivalent to 9.6 percent annual rate compounded semiannually, or 9.8

percent (1.0482 - 1) compounded annually.

236

5

$90 $1,000

7-7. $1200 = ∑

t =1 (1 + k b )5

+

(1 + k b )5

5 N

1200 +/- PV

90 PMT

1000 FV

CPT I/Y → ANSWER 4.45%

20

$90 $1,000

7-8. $945 = ∑ (1 + k b ) t

+

(1 + k b )20

t =1

20 N

945 +/- PV

90 PMT

1000 FV

CPT I/Y → ANSWER 9.63

12

$70 $1,000

7-9. $1,150 = ∑ (1 + k b ) t

+

(1 + k b )12

t =1

12 N

1150 +/- PV

70 PMT

1000 FV

CPT I/Y → ANSWER 5.28

237

15

$80 $1,000

7-10. a. $1,085 = ∑ (1 + k b ) t

+

(1 + k b )15

t =1

15 N

1085 +/- PV

80 PMT

1000 FV

CPT I/Y → ANSWER 7.06

15

$80 $1,000

b. Vb = ∑ (1.10) t

+

(1.10)15

t =1

15 N

10 I/Y

80 PMT

1000 FV

CPT PV → ANSWER -847.88

c. Since the expected rate of return, 7.06 percent, is less than your required rate

of return of 10 percent, the bond is not an acceptable investment. This fact is

also evident because the market price, $1,085, exceeds the value of the

security to the investor of $847.48.

7-11. a. Value

Par Value $1,000.00

Coupon $ 100.00

Required Rate of Return 0.12

Years to Maturity 15

Market Value $ 863.78

b. Value at Alternative Rates of Return

Required Rate of Return 0.15

Market Value $ 707.63

Market Value $1,171.19

238

c. As required rates of return change, the price of the bond changes, which is the

result of "interest-rate risk" Thus, the greater the investor's required rate of

return, the greater will be his/her discount on the bond. Conversely, the less

his/her required rate of return below that of the coupon rate, the greater the

premium will be.

d. Value at Alternative Maturity Dates

Years to Maturity 5

Required Rate of Return 0.12

Market Value $ 927.90

Required Rate of Return 0.15

Market Value $ 832.39

Required Rate of Return 0.08

Market Value $1,079.85

e. The longer the maturity of the bond, the greater the interest rate risk the

investor is exposed to, resulting in greater premiums and discounts.

7-12. a. Value

Par Value $1,000.00

Coupon $ 80.00

Required Rate of Return 0.07

Years to Maturity 20

Market Value $1,106.00

Required Rate of Return 0.10

Market Value $830.00

Market Value $1,229.00

c. As required rates of return change, the price of the bond changes, which is the

result of "interest-rate risk" Thus, the greater the investor's required rate of

return, the greater will be his/her discount on the bond. Conversely, the less

his/her required rate of return below that of the coupon rate, the greater the

premium will be.

Years to Maturity 10

Required Rate of Return 0.07

Market Value $1,070.00

Required Rate of Return 0.10

Market Value $877.00

Required Rate of Return 0.06

Market Value $1,147.00

239

e. The longer the maturity of the bond, the greater the interest rate risk the

investor is exposed to, resulting in greater premiums and discounts.

1

7-13. PV = FVn

(1 + i)n

1

PV = $1,000

7

(1 + .09)

PV = $1,000(.547)

PV = $547

7-14. The solutions in this problem are based on the present value appendixes, rather than

using a financial calculator. Either approach will provide the same answers, subject

to rounding errors.

a. Bond Value = of Interest + the Return of the

at 10 Percent Payments Principal

i = 10% + i = 10%

= n = 3 n = 3

= 2 m =

m 2

n ⋅m 1

= PMT ∑

1

+ FVnm i

t = 1 (1 + i ) t (1 + )nm

m

m

6

1 1

= $50 ∑ + $1000 (1 + .05)6

t = 1 (1 + .05)

t

= $50(5.076) + $1000(.746)

= $253.80 + $746

= $999.80

(Actually it is equal to $1000 but the calculations are off somewhat due to

rounding error in the tables.)

240

Bond B 7 x2

+ $1000

1 1

Bond Value = $50 ∑

t = 1 (1 + .10 ) t .10

at 10 Percent (1 + )7x2

2 2

14

1 1

= $50 ∑ + $1000 (1 + .05)14

t = 1 (1 + .05)

t

= $50(9.899) + $1000(.505)

= $494.95 + $505

= $999.95 (again different from $1000 only because of

rounding error)

Bond C 20 x 2

+ $1000

1 1

Bond Value = $50 ∑

t = 1 (1 + .10 ) t .10

at 10 Percent (1 + )20x2

2 2

40 t

1 1 40

= $50 ∑ + $1000

t = 1 (1 + .05) (1 + .05)

= $50(17.159) + $1000(.142)

= $857.95 + $142

= $999.95 (again different from $1000 only because of

rounding error)

Bond A 6

1 1

b. Bond Value = $50 ∑ t

+ $1000

at 4 percent t = 1 (1 + .02) 6

(1 + .02)

= $50(5.601) + $1,000(.888)

= $280.05 + $888

= $1168.05

Bond B 14

1 1

Bond Value = $50 ∑ + $1000 (1 + .02)14

t = 1 (1 + .02)

t

at 4 percent

= $50(12.106) + $1,000(.758)

= $605.30 + $758

= $1363.30

241

Bond C 40

1 1

Bond Value = $50 ∑ + $1000

t = 1 (1 + .02) 40

(1 + .02)

t

at 4 percent

= $50(27.356) + $1,000(.453)

= $1367.80 + $453

= $1820.80

Bond A 6

Bond Value = $50 ∑

1 1

c. + $1000

at 16 percent = (1 + .08) t 6

(1 + .08)

t 1

= $50(4.623) + $1,000 (.630)

= $231.15 + $630

= $861.15

Bond B 14

Bond Value = $50 ∑

1 1

(1 + .08) t + $1000 (1 + .08)14

at 16 percent t = 1

= $50(8.244) + $1,000(.340)

= $412.20 + $340

= $752.20

Bond C 40

Bond Value = $50 ∑

1 1

(1 + .08) t + $1000 (1 + .08)40

at 16 percent t = 1

= $50(11.925) + $1,000(.046)

= $596.25 + $46

= $642.25

d. First, if the market discount rate and the bonds coupon rate are identical, then

the bond's value will be equal to its principal value, in this case $1,000.

Second, when interest rates change, bonds with longer to maturity change

more in value than do bonds with shorter maturities.

242

SOLUTION TO MINI CASE

3

$63.75 $1,000

a. Bell South Bond Value (Vb) = ∑

t =1 (1 + .07)i

+

(1 + .07)3

3 N

7 I/Y

63.75 PMT

1000 FV

CPT PV → ANSWER -$983.60

8

$78.75 $1,000

Dole Bond Value (Vb) = ∑

t =1 (1 + .075)i

+

(1 + .075)8

= $78.75 (5.8573) + $1,000 (.5607)

= $461.26 + $560.7

= $1,021.96

8 N

7.5 I/Y

78.75 PMT

1000 FV

CPT PV → ANSWER -$1021.96

11

$72.00 $1,000

Xerox Value (Vb) = ∑

t =1 (1 + .10)i

+

(1 + .10)11

11 N

10 I/Y

72.00 PMT

1000 FV

CPT PV → ANSWER -$818.14

243

b. To compute the expected rate of return for each bond, use a financial calculator to

solve the following equation:

Bell South:

3

$63.75 $1,000

$983.75 = ∑

t =1 (1 + k b )i

+

(1 + k b )3

3 N

983.75 +/- PV

63.75 PMT

1000 FV

CPT I/Y → ANSWER 6.99%

Dole:

8

$78.75 $1,000

$1030.00 = ∑t =1 (1 + k b ) t

+

(1 + k b )8

8 N

1030 +/- PV

78.75 PMT

1000 FV

CPT I/Y → ANSWER 7.37%

Xerox:

11

$72.00 $1,000

$1047.50 = ∑

t =1 (1 + k b ) t

+

(1 + k b )11

11 N

1047.50 +/- PV

72 PMT

1000 FV

CPT I/Y ANSWER 6.58%

244

3

$63.75 $1,000

c.(1) Bell South Value (Vb) = ∑

t =1 (1 + .09) t

+

(1 + .09)3

3 N

9 I/Y

63.75 PMT

1000 FV

CPT PV → ANSWER - $933.55

8

$78.75 $1,000

Dole Value (Vb) = ∑

t =1 (1 + .095) t

+

(1 + .095)8

8 N

9.5 I/Y

78.75 PMT

1000 FV

CPT PV → ANSWER - $911.71

Xerox 11

$72.00 $1,000

Bond Value

(Vb) = ∑

t =1 (1 + .12) t

+

(1 + .12)11

11 N

12 I/Y

72.00 PMT

1000 FV

CPT PV → ANSWER - $714.99

245

3

$63.75 $1,000

c.(2) Bell South Value (Vb) = ∑

t =1 (1 + .05)t

+

(1 + .05)3

3 N

5 I/Y

63.75 PMT

1000 FV

CPT PV → ANSWER - $1037.44

8

$78.75 $1,000

Dole Bond Value (Vb) = ∑

t =1 (1 + .055)t

+

(1 + .055)8

8 N

5.5 I/Y

78.75 PMT

1000 FV

CPT PV → ANSWER - $1150.45

Xerox 11

$72.00 $1,000

Bond Value

(Vb) = ∑

t =1 (1 + .08) t

+

(1 + .08)11

11 N

8 I/Y

72.00 PMT

1000 FV

CPT PV → ANSWER - $942.89

d. As the interest rates rise and fall, we see the different effects on the bond

prices depending on the length of time to maturity and whether the investor's

required rate of return is above or below the coupon interest rate. If the

investor’s required rate of return is above the coupon interest rate, the bond

will sell at a discount (below par value), but if the investor’s required rate of

return is below the coupon interest rate, the bond will sell at a price above its

par value (premium).

e. The Bell South, Dole and Xerox bonds have a lower expected rate of return

than your required rate of return. So we would not buy all of them.

246

ALTERNATIVE PROBLEMS AND SOLUTIONS

ALTERNATIVE PROBLEMS

7-1A. (Bond Valuation) Calculate the value of a bond that expects to mature in 10 years and

has a $1,000 face value. The coupon interest rate is 9 percent and the investors’

required rate of return is 15 percent.

7-2A. (Bond Valuation) Pybus, Inc. bonds have a 10 percent coupon rate. The interest is

paid semiannually and the bonds mature in 11 years. Their par value is $1,000. If

your required rate of return is 9 percent, what is the value of the bond? What is its

value if the interest is paid annually?

7-3A. (Bond Yield: Bondholder Expected Rate of Return) The market price is $950 for an

8-year bond ($1,000 par value) that pays 9 percent interest (4.5 percent

semiannually). What is the bond’s expected rate of return?

7-4A. (Bond Valuation) Doisneau 20-year bonds pay 10 percent interest annually on a

$1,000 par value. If the bonds sell at $975, what is the bond’s expected rate of return?

7-5A. (Bond Yield: Bondholder Expected Rate of Return) Hoyden Co.’s bonds mature in

15 years and pay 8 percent interest annually. If you purchase the bonds for $1,175,

what is your expected rate of return?

7-6A. (Bond Valuation) Fingen’s 14-year, $1,000 par value bonds pay 9 percent interest

annually. The market price of the bonds is $1,100 and your required rate of return is

10 percent.

a. Compute the bond’s expected rate of return.

b. Determine the value of the bond to you, given you required rate of return.

c. Should you purchase the bond?

7-7A. (Bond Valuation) You own a bond that pays $75 in annual interest, with a $1,000 par

value. It matures in 15 years. Your required rate of return is 6 percent.

a. Calculate the value of the bond.

b. How does the value change if your required rate of return (i) increases to 10

percent or (ii) decreases to 4 percent?

c. Explain the implications of your answers in part (b) as they relate to interest

rate risk, premium bonds, and discount bonds.

d. Assume that the bond matures in 5 years instead of 15 years. Recompute your

answers in part (b).

e. Explain the implications of your answers in part (d) as they relate to interest

rate risk, premium bonds, and discount bonds.

7-8A. See Problem 7-7A for an alternative problem for Problem 7-8.

247

SOLUTIONS TO ALTERNATIVE PROBLEMS

10

$90 $1,000

7-1A. Value (Vb) = ∑ (1 + .15) t

+

(1 + .15)10

t =1

= $451.62 + $247.00

= $698.62

10 N

15 I/Y

90 PMT

1000 FV

CPT PV → ANSWER -698.87

22

$50 $1,000

Value (Vb) = ∑ (1.045) t

+

(1.045)22

t =1

Vb = $1,069.20

22 N

4.5 I/Y

50 PMT

1000 FV

CPT PV → ANSWER -1068.92

248

If interest is paid annually:

11

$100 $1,000

Value (Vb) = ∑ (1.09)t

+

(1.09)11

t =1

Vb = $1,068.50

11 N

9 I/Y

100 PMT

1000 FV

CPT PV → ANSWER -1068.05

16

$45 $1,000

7-3A. $950 = ∑ (1 + k b /2) t

+

(1 + k b /2)16

t =1

16 N

950 +/- PV

45 PMT

1000 FV

CPT I/Y → ANSWER 4.96

10.17 percent (1.04962 - 1) compounded annually.

20

$100 $1,000

7-4A. $975 = ∑ (1 + k b ) t

+

(1 + k b )20

t =1

20 N

975 +/- PV

100 PMT

1000 FV

CPT I/Y → ANSWER 10.30

249

15

$80 $1,000

7-5A. $1,175 = ∑ (1 + k b ) t

+

(1 + k b )15

t =1

15 N

1175 +/- PV

80 PMT

1000 FV

CPT I/Y → ANSWER 6.18

14

$90 $1,000

7-6A. a. $1,100 = ∑ (1 + kb) t

+

(1 + kb)14

t =1

14 N

1100 +/- PV

90 PMT

1000 FV

CPT I/Y → ANSWER 7.80

14

$90 $1,000

b. Vb = ∑ (1.10) t

+

(1.10)14

t =1

Vb = $90(7.367) + $1,000(0.263)

Vb = $926.03

14 N

10 I/Y

90 PMT

1000 FV

CPT PV → ANSWER -926.33

c. Since the expected rate of return, 7.82 percent, is less than your required rate

of return of 10 percent, the bond is not an acceptable investment. This fact is

also evident because the market price, $1,100, exceeds the value of the

security to the investor of $926.03.

250

7-7A a. Value

Par Value $1,000.00

Coupon $ 75.00

Required Rate of Return 0.06

Years to Maturity 15

Market Value $ 1,145.68

Required Rate of Return 0.10

Market Value $ 809.85

Market Value $1,389.14

c. As required rates of return change, the price of the bond changes, which is the

result of "interest-rate risk." Thus, the greater the investor's required rate of

return, the greater will be his/her discount on the bond. Conversely, the less

his/her required rate of return below that of the coupon rate, the greater the

premium will be.

Years to Maturity 5

Required Rate of Return 0.06

Market Value $ 1,063.19

Required Rate of Return 0.10

Market Value $ 905.23

Required Rate of Return 0.04

Market Value $1,155.82

e. The longer the maturity of the bond, the greater the interest-rate risk the

investor is exposed to, resulting in greater premiums and discounts.

251

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