Chapter 7, Problem 20IC

### 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 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. What are a bond's key features? b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? c. How is the value of any asset whose value is based on expected future cash flows determined? 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%? e. 1. What is the value of a 13% coupon bond that is otherwise identical to the bond described in part d? Would we now have a discount or a premium bond? 2. What is the value of a 7% coupon bond with these characteristics? Would we now have a discount or premium bond?3. What would happen to the values of the 7%, 10%, and 13% coupon bonds over time if the required return remained at 10%? (Hint: With a financial calculator, enter PMT, I/YR, FV, and N; then change (override) N to see what happens to the PV as it approaches maturity.) f. 1. What is the yield to maturity on a 10-year, 9% annual coupon,$1,000 par value bond that sells for $887.00? That sells for$1,134.20? What does the fact that it sells at a discount or at a premium tell you about the relationship between rd and the coupon rate? a. 2. What are the total return, the current yield, and the capital gains yield for the discount bond? Assume that it is held to maturity, and the company does not default on it. (Hint: Refer to footnote 6 for the definition of the current yield and to Table 7.1.) g. What is price risk? Which has more price risk, an annual payment 1-year bond or a 10-year bond? Why? h. What is reinvestment risk? Which has more reinvestment risk, a 1-year bond or a 10-vear bond? i. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment. 10% coupon bond if nominal rd = 13% j. Suppose for $1,000 you could buy a 10%, 10-year, annual payment bond or a 10%, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If$1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond? k. Suppose a 10-year, 10% semiannual coupon bond with a par value of $1,000 is currently selling for$1,135.90, producing a nominal yield to maturity of 8%. However, it can be called after 4 years for \$1,050. 1. What is the bond's nominal yield to call (YTC)? 2. If you bought this bond, would you be more likely to earn the YTM or the YTC? Why? l. Does the yield to maturity represent the promised or expected return on the bond? Explain. m. These bonds were rated AA – by S&P. Would you consider them investment-grade or junk bonds? n. What factors determine a company’s bond rating? o. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments? Explain.

a)

Summary Introduction

To identify: The bond’s key features.

Introduction:

Bond valuation refers to the evaluation of bond value at any point of time, which can be used for decision-making. Valuation of bond is done for comparison and analysis.

Explanation
• Coupon rate is the rate of interest paid annually or semiannually as a cost of borrowed debt.
• Par value refers to the face value of the bond that is the amount borrowed or amount to be paid on maturity.
• Maturity date is the period at which bond par worth is repaid to the investors...

b)

Summary Introduction

To explain: The call provision and sinking fund provision and whether these provisions make bonds more or less risky.

c)

Summary Introduction

To identify: The way to determine the asset worth whose value is based on anticipated future cash flows.

d)

Summary Introduction

To identify: The way to determine the value of bond.

e)1.

Summary Introduction

To identify: The value of bond at 13% coupon rate and whether it gives a discount or premium bonds.

2.

Summary Introduction

To identify: The value of bond at 7% coupon rate with characteristics and whether it gives a discount or premium bonds.

3.

Summary Introduction

To identify: The changes in value of three bonds with 7%, 10%, and 13% coupon rate if the required return remained at 10%.

f)1.

Summary Introduction

To identify: The yield to maturity and the discount or premium tells about the relationship between coupon rate and rd.

2.

Summary Introduction

To identify: The yield to maturity, total return, the current yield and the capital gain yield.

g)

Summary Introduction

To explain: The price risk and whether an annual payment of 1-year or 10-year bond has more price risk.

h)

Summary Introduction

To explain: Reinvestment risk and whether the 1-year or 10-year bond has more reinvestment risk.

i)

Summary Introduction

To identify: The change in the equation for valuing a bond if semiannual payments are made.

Summary Introduction

To determine:  The value of the bond

j)

Summary Introduction

To identify: The preferable bond and equilibrium price for the annual payment bond.

k)

Summary Introduction

To identify: The bonds nominal yield to call.

2.

Summary Introduction

To identify: Yield to maturity or Yield to call which one is more likely to earn and the reason.

l)

Summary Introduction

To explain: Whether the yield to maturity represents the promised or expected return on the bond.

m)

Summary Introduction

To explain: Whether the bonds rated AA are considered as investment-grade or junk bonds.

n)

Summary Introduction

To explain: The factors determining company’s bond rating.

o)

Summary Introduction

To explain: Whether the default on the bonds results in immediate liquidation of the company and whether the bondholders are assured of receiving promised payments.

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