Financial Management-Chapter 7 Solution- Gitman

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Financial Management-chapter 7 solution- Gitman

7-21

Western Money Management Inc.

Bond Valuation

Robert Black and Carol Alvarez are vice presidents of Western Money Management and codirectors of the company’s pension fund management division. A major new client, the California League of Cities, has requested that Western present an investment seminar to the mayors of the represented cities. Black and Alvarez, who will make the presentation, have asked you to help them by answering the following questions. A. Answer: What are a bond’s key features? [Show S7-1 through S7-4 here.] If possible, begin this lecture by showing students an actual bond certificate. We show a real coupon bond with physical coupons. These can no longer
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Thus, the discount rate depends primarily on factors discussed in Chapter 7: ri = r* + IP + MRP + DRP+ LP.

4

Integrated Case

Chapter 7: Bonds and Their Valuation

D.

How is a bond’s value determined? What is the value of a 10-year, $1,000 par value bond with a 10% annual coupon if its required return is 10%?

Answer:

[Show S7-11 and S7-12 here.] A bond has a specific cash flow pattern consisting of a stream of constant interest payments plus the return of par at maturity. The annual coupon payment is the cash flow: PMT = (Coupon rate)  (Par value) = 0.1($1,000) = $100. For a 10-year, 10% annual coupon bond, the bond’s value is found as follows: 0 1 | 10% | 100 90.91 82.64 . . . 38.55 385.54 1,000.00 2 | 100 3 | 100


9 | 100

10 | 100 1,000

Expressed as an equation, we have:

VB 

$100 $100 $1,000  ...   1 10 (1  rd )10 (1  rd ) (1  rd )

 $90.91  ...  $38.55  $385.54  $1,000. The bond consists of a 10-year, 10% annuity of $100 per year plus a $1,000 lump sum payment at t = 10: PV annuity PV maturity value Value of bond = $ 614.46 = 385.54 = $1,000.00

Chapter 7: Bonds and Their Valuation

Integrated Case

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The mathematics of bond valuation is programmed into financial calculators that do the operation in one step, so the easy way to solve bond valuation problems is with a financial calculator.

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