Chapter 7, Problem 19SP

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# BOND VALUATION Clifford Clark is a recent retiree who is interested in investing some of his savings in corporate bonds. His financial planner has suggested the following bonds: Bond A has a 7% annual coupon, matures in 12 years, and has a $1,000 face value. Bond B has a 9% annual coupon, matures in 12 years, and has a$1,000 face value. Bond C has an 11% annual coupon, matures in 12 years, and has a $1,000 face value. Each bond has a yield to maturity of 9%. a. Before calculating the prices of the bonds, indicate whether each bond is trading at a premium, at a discount, or at par. b. Calculate the price of each of the three bonds. c. Calculate the current yield for each of the three bonds. (Hint: Refer to footnote 6 for the definition of the current yield and to Table 7.1.) d. If the yield to maturity for each bond remains at 9%, what will be the price of each bond 1 year from now? What is the expected capital gains yield for each bond? What is the expected total return for each bond? e. Mr. Clark is considering another bond. Bond D. It has an 8% semiannual coupon and a$1,000 face value (i.e., it pays a $40 coupon every 6 months). Bond D is scheduled to mature in 9 years and has a price of$1,150. It is also callable in 5 years at a call price of \$1,040. 1. What is the bond's nominal yield to maturity? 2. What is the bond's nominal yield to call? 3. If Mr. Clark were to purchase this bond, would he be more likely to receive the yield to maturity or yield to call? Explain your answer. f. Explain briefly the difference between price risk and reinvestment risk. Which of the following bonds has the most price risk? Which has the most reinvestment risk? A 1-year bond with a 9% annual coupon A 5-year bond with a 9% annual coupon A 5-year bond with a zero coupon A 10-year bond with a 9% annual coupon A 10-year bond with a zero coupon g. Only do this part if you are using a spreadsheet. Calculate the price of each bond (A, B, and C) at the end of each year until maturity, assuming interest rates remain constant. Create a graph showing die time path of each bond’s value, similar to that shown in Figure 7.2. 1. What is the expected interest yield for each bond in each year? 2. What is the expected capital gains yield for each bond in each year? 3. What is the total return for each bond in each year?

a)

Summary Introduction

To identify: Whether the bonds are issued at par, discount, and at premium.

Introduction:

Discount refers to a situation where price issued for the bond is below the par value of the bond.

Premium refers to a situation where price issued for the bond is above the bond’s par value.

Par value of bond also mentioned as the face value of the bond is the original price printed on the bond certificate. A bond is considered to be issued at par when yield to maturity of a bond is equivalent to the bond’s coupon rate.

Explanation

Given information:

Yield to maturity is 9%.

Bond A has 7% annual coupon rate.

Bond B has 9% annual coupon rate.

Bond C has 11% annual coupon rate.

Whether the bonds are issued at par, discount, and at premium are as follows:

Bond A has an annual coupon rate of 7% which is less than the required return of 9%, it means that the bond is being traded at below the par value or at discount...

b)

Summary Introduction

To compute: Price of bonds.

Introduction:

Bonds are a financial instrument, generally issued to raise debt generally for activities which require a significant amount of funds, with an undertaking to repay the amount with appropriate interest.

c)

Summary Introduction

To compute: Current yield.

Introduction:

Current yield is the anticipated rate of return on the basis of annual coupon payment and present market price of a bond.

d)

Summary Introduction

To compute: Price of each bond 1 year from now.

Summary Introduction

To determine: The expected capital gain for each bond.

Summary Introduction

To determine: The expected total return for each bond.

e)1.

Summary Introduction

To compute: Bond’s normal yield to maturity.

2.

Summary Introduction

To compute: Yield to call

3.

Summary Introduction

To identify: Decision to choose between yield to maturity or yield to call.

f.

Summary Introduction

To identify: Difference between price risk and reinvestment risk.

Summary Introduction

To rank: The bonds have the most price risk.

Summary Introduction

To rank: The bonds have the most reinvestment risk.

g)

Summary Introduction

To determine: The price of each bond A, bond B, and bond C at the end of each year until maturity.

Summary Introduction

To graph: The time path of each bond's value.

g)1.

Summary Introduction

To compute: Expected interest rate for each bond in each year.

2.

Summary Introduction

To compute: Expected capital gains yield for each bond in every year.

3.

Summary Introduction

To compute: Total return for each bond in every year.

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