Chapter 06 - Valuing Bonds

Solutions to Chapter 6

Valuing Bonds

1. a. Coupon rate = 6%, which remains unchanged. The coupon payments are fixed
at $60 per year.

b. When the market yield increases, the bond price will fall. The cash flows are
discounted at a higher rate.

c. At a lower price, the bond’s yield to maturity will be higher. The higher yield to
maturity for the bond is commensurate with the higher yields available in the rest
of the bond market.

d. Current yield = coupon rate/bond price

As the coupon rate remains the same and the bond price decreases, the current
yield increases.

Est time: 01–05

2. When the bond is selling at a discount, $970 in this case, the yield to maturity is
greater than 8%. We know that if the yield to maturity were 8%, the bond would sell
at par. At a price below par, the yield to maturity exceeds the coupon rate.

Est time: 01–05

3. Coupon payment = 0.08  $1,000 = $80

Current yield = $80/bond price = 0.06
Therefore: Bond price = $80/0.06 = $1,333.33

Est time: 01–05

4. Coupon rate = $80/$1,000 = 0.080 = 8.0%

To compute the yield to maturity, use trial and error to solve for r in the following
equation:
1 1  $1,000
$950  $80    6
  r = 9.119%
 r r  (1  r )  (1  r )
6

Using a financial calculator, compute the yield to maturity by entering

n = 6, PV = ()950, FV = 1,000, PMT = 80; compute i = 9.119%.

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Chapter 06 - Valuing Bonds

Verify the solution as follows:

 1 1  $1,000
PV  $80    6 
 6
 $949.98
 0.09119 0.09119(1.09119)  1.09119
(difference due to rounding)

Est time: 01–05

5. In order for the bond to sell at par, the coupon rate must equal the yield to maturity.
Since Circular bonds yield 9.119%, this must be the coupon rate.
Est time: 01–05

6. a. Current yield = coupon/price = $80/$1,100 = 0.0727 = 7.27%

b. To compute the yield to maturity, use trial and error to solve for r in the
following equation:
1 1  $1,000
$1,100  $80    8
  r = 6.3662%
 r r  (1  r )  (1  r )
8

Using a financial calculator, compute the yield to maturity by entering

n = 8, PV = ()1,100, FV = 1,000, PMT = 80; compute i = 6.3662%.

Est time: 01–05

7. When the bond is selling at face value, its yield to maturity equals its coupon rate. This
firm’s bonds are selling at a yield to maturity of 9.25%. So the coupon rate on the new
bonds must be 9.25% if they are to sell at face value.

Est time: 01–05

8. The bond pays a coupon of 8.75%, which means annual interest is $87.50. The
bond is selling for 144 19/32 = $1,445.9375. Therefore, the current yield is
$87.50/$1445.9375 = 6.05%.
The current yield exceeds the yield to maturity on the bond because the bond is selling at
a premium. At maturity the holder of the bond will receive only the $1,000 face value,
reducing the total return on investment.

Est time: 01–05

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9. Bond 1:
 1 1  $1,000
Year 1: PV  $80    10 
 10
 $877.11
 0.10 0.10(1.10)  1.10

 1 1  $1,000
Year 2: PV  $80    9 
 9
 $884.82
 0.10 0.10(1.10)  1.10
Using a financial calculator:
Year 1: PMT = 80, FV = 1,000, i = 10%, n = 10; compute PV0 = $877.11.
Year 2: PMT = 80, FV = 1,000, i = 10%, n = 9; compute PV1 = $884.82.
$80  ($884.82  $877.11)
Rate of return =  0.100  10.0%
$877.11
Bond 2:
 1 1  $1,000
Year 1: PV  $120    10 
 10
 $1,122.89
 0 . 10 0 . 10 (1 . 10 )  1 . 10

 1 1  $1,000
Year 2: PV  $120    9 
 9
 $1,115.18
 0.10 0.10(1.10)  1.10
Using a financial calculator:
Year 1: PMT = 120, FV = 1,000, i = 10%, n = 10; compute PV0 = $1,122.89.
Year 2: PMT = 120, FV = 1,000, i = 10%, n = 9; compute PV1 = $1,115.18.
$120  ($1,115.18  $1,122.89)
Rate of return =  0.100  10.0%
$1,122.89
Both bonds provide the same rate of return.
Est time: 01–05

10. a. If yield to maturity = 8%, price will be $1,000.

b. Rate of return =
coupon income  price change $80  ($1,000  $1,100)
  0.0182  1.82%
investment $1,100

1 + nominal interest rate 0.9818

c. Real return = 1 + inflation rate 1=  1  0.0468  4.68%
1.03

Est time: 01–05

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Chapter 06 - Valuing Bonds

11. a. With a par value of $1,000 and a coupon rate of 8%, the bondholder receives
$80 per year.

 1 1  $1,000
b. PV  $80    9 
  $1,065.15
 0.07 0.07  (1.07)  (1.07)
9

c. If the yield to maturity is 6%, the bond will sell for:

 1 1  $1,000
PV  $80    9 
  $1,136.03
 0.06 0.06  (1.06)  (1.06)
9

Est time: 01–05

12. a. To compute the yield to maturity, use trial and error to solve for r in the
following equation:
1 1  $1,000
$900  $80    30 
  r = 8.971%
 r r  (1  r )  (1  r )
30

Using a financial calculator, compute the yield to maturity by entering

n = 30, PV = ()900, FV = 1,000, PMT = 80; compute i = 8.971%.
Verify the solution as follows:
 1 1  $1,000
PV  $80    30 
 30
 $899.99
 0.08971 0.08971(1.08971)  1.08971
(difference due to rounding)

b. Since the bond is selling for face value, the yield to maturity = 8.000%.

c. To compute the yield to maturity, use trial and error to solve for r in the
following equation:
1 1  $1,000
$1,100  $80    30 
  r = 7.180%
 r r  (1  r )  (1  r )
30

Using a financial calculator, compute the yield to maturity by entering

n = 30, PV = ()1,100, FV = 1,000, PMT = 80; compute i = 7.180%.
Verify the solution as follows:
 1 1  $1,000
PV  $80    30 
 30
 $1,099.94
 0.07180 0.07180(1.07180)  1.07180
(difference due to rounding)
Est time: 06–10

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13. a. To compute the yield to maturity, use trial and error to solve for r in the
following equation:
1 1  $1,000
$900  $40    60 
  r = 4.483%
 r r  (1  r )  (1  r )
60

Using a financial calculator, compute the yield to maturity by entering

n = 60, PV = ()900, FV = 1,000, PMT = 40; compute i = 4.483%.
Verify the solution as follows:
 1 1  $1,000
PV  $40    60 
 60
 $900.02
 0.04483 0.04483(1.04483)  1.04483
(difference due to rounding)
Therefore, the annualized bond equivalent yield to maturity is:
4.483%  2 = 8.966%

b. Since the bond is selling for face value, the semiannual yield = 4%.
Therefore, the annualized bond equivalent yield to maturity is 4%  2 = 8%.

c. To compute the yield to maturity, use trial and error to solve for r in the
following equation:
1 1  $1,000
$1,100  $40    60 
  r = 3.592%
 r r  (1  r )  (1  r )
60

Using a financial calculator, compute the yield to maturity by entering

n = 60, PV = ()1,100, FV = 1,000, PMT = 40; compute i = 3.592%.
Verify the solution as follows:
 1 1  $1,000
PV  $40    60 
 60
 $1,099.92
 0.03592 0.03592(1.03592)  1.03592
(difference due to rounding)
Therefore, the annualized bond equivalent yield to maturity is:
3.592%  2 = 7.184%

Est time: 06–10

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Chapter 06 - Valuing Bonds

14. In each case, we solve the following equation for the missing variable:
Price = $1,000/(1 + y)maturity
Price Maturity (Years) Yield to Maturity
$300.00 30.00 4.095%
$300.00 15.64 8.000%
$385.54 10.00 10.000%

Est time: 01–05

15. PV of perpetuity = coupon payment/rate of return

PV = C/r = $60/0.06 = $1,000.00
If the required rate of return is 10%, the bond sells for:
PV = C/r = $60/0.10 = $600.00

Est time: 01–05

16. Current yield = 0.098375, so bond price can be solved from the following:
$90/price = 0.098375  price = $914.87
To compute the remaining maturity, solve for t in the following equation:
 1 1  $1,000
$914.87  $90    t
  t = 20.0
 0.10 0.10  (1.10)  (1.10)
t

Using a financial calculator, compute the remaining maturity by entering

PV = ()914.87, FV = 1,000, PMT = 90, i = 10; compute n = 20.0 years.

Est time: 01–05

17. Solve the following equation for PMT:

 1 1  $1,000
$1,065.15  PMT    9 
  PMT = $80.00
 0.07 0.07  (1.07)  (1.07)
9

Using a financial calculator, compute the annual payment by entering

n = 9, PV = ()1,065.15, FV = 1,000, i = 7; compute PMT = $80.00.
Since the annual payment is $80, the coupon rate is 8%.

Est time: 01–05

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18. a. The coupon rate must be 7% because the bonds were issued at face value with
a yield to maturity of 7%. Now the price is:
 1 1  $1,000
PV  $70    8
 8
 $641.01
 0.15 0.15(1.15)  1.15

b. The investors pay $641.01 for the bond. They expect to receive the promised
coupons plus $800 at maturity. We calculate the yield to maturity based on these
expectations by solving the following equation for r:
1 1  $800
$641.01  $70    8
  r = 12.87%
 r r  (1  r )  (1  r )
8

Using a financial calculator, enter n = 8, PV = ()641.01, FV = 800, PMT = 70;

then compute i = 12.87%.

Est time: 06–10

19. a. At a price of $1,200 and remaining maturity of 9 years, find the bond’s yield
to maturity by solving for r in the following equation:
1 1  $1,000
$1,200  $80    9
  r = 5.165%
 r r  (1  r )  (1  r )
9

Using a financial calculator, enter n = 9, PV = ()1,200, FV = 1,000, PMT = 80;

then compute i = 5.165%.

$80  ($1,200  $980)

b. Rate of return =  30.61%
$980

Est time: 01–05

 1 1  $1,000
20. PV0  $80    20 
 20
 $908.71
 0. 09 0. 09(1 . 09)  1.09

 1 1  $1,000
PV1  $80    19 
 19
 $832.70
 0.10 0.10(1.10)  1.10
$80  ($832.70  $908.71)
Rate of return =  0.0044  0.44%
$908.71

Est time: 01–05

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Chapter 06 - Valuing Bonds

21. a., b.

Price of Each Bond at Different Yields to Maturity

Maturity of Bond
Yield 4 Years 8 Years 30 Years
7% $1,033.87 $1,059.71 $1,124.09
8% $1,000.00 $1,000.00 $1,000.00
9% $967.60 $944.65 $897.26

c. The table shows that prices of longer-term bonds are more sensitive to
changes in interest rates.

Est time: 06–10

22. The price of the bond at the end of the year depends on the interest rate at that time.
With 1 year until maturity, the bond price will be $1,080/(1 + r).
a. Price = $1,080/1.06 = $1,018.87
Rate of return = [$80 + ($1,018.87  $1,000)]/$1,000 = 0.0989 = 9.89%
b. Price = $1,080/1.08 = $1,000.00
Rate of return = [$80 + ($1,000  $1,000)]/$1,000 = 0.0800 = 8.00%
c. Price = $1,080/1.10 = $981.82
Rate of return = [$80 + ($981.82  $1,000)]/$1,000 = 0.0618 = 6.18%

Est time: 01–05

23. The original price of the bond is computed as follows:

 1 1  $1,000
PV  $40    30 
 30
 $627.73
 0.07 0.07(1.07)  1.07
After 1 year, the maturity of the bond will be 29 years, and its price will be:
 1 1  $1,000
PV  $40    29 
 29
 $553.66
 0.08 0.08(1.08)  1.08
The capital loss on the bond is $74.07. The rate of return is therefore:
($40  $74.07)/$627.73 = 0.0543 = 5.43%

Est time: 06–10

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Chapter 06 - Valuing Bonds

24. The bond’s yield to maturity will increase from 7.5% to 7.8% when the perceived
default risk increases. The bond price will fall:
 1 1  $1,000
Initial price = PV  $70    10 
 10
 $965.68
 0.075 0.075(1.075)  1.075

 1 1  $1,000
New price = PV  $70    10 
 10
 $945.83
 0.078 0.078(1.078)  1.078

Est time: 01–05

25. The nominal rate of return is 7% ($70/$1,000).

The real rate of return is [1.07/(1 + inflation)]  1.
a. 1.07/1.02  1 = 0.0392 = 4.902%

b. 1.07/1.04  1 = 0.0192 = 2.885%

c. 1.07/1.06  1 = 0.009434 = 0.9434%

d. 1.07/1.08  1 = 0.00926 = 0.926%

Est time: 01–05

26. The principal value of the bond will increase by the inflation rate, and since the coupon
is 4% of the principal, the coupon will also increase along with the general level of
prices. The total cash flow provided by the bond will be:
1,000  (1 + inflation rate) + coupon rate  1,000  (1 + inflation rate)
Since the bond is purchased for face value, or $1,000, total dollar nominal return is
therefore the increase in the principal due to the inflation indexing, plus coupon income:
Income = ($1,000  inflation rate) + [coupon rate  $1,000  (1 + inflation rate)]
Finally: Nominal rate of return = income/$1,000

$20  ($40  1.02)

a. Nominal rate of return =  0.0608  6.08%
$1,000
1.0608
Real rate of return =  1  0.0400  4.00%
1.02

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$40  ($40  1.04)

b. Nominal rate of return =  0.0816  8.16%
$1,000
1.0816
Real rate of return =  1  0.0400  4.00%
1.04

$60  ($40  1.06)

c. Nominal rate of return =  0.1024  10.24%
$1,000
1.1024
Real rate of return =  1  0.0400  4.00%
1.06

$80  ($40  1.08)

d. Nominal rate of return =  0.1232  12.32%
$1,000
1.1232
Real rate of return =  1  0.0400  4.00%
1.08

Est time: 06–10

27.
First-Year Cash Flow Second-Year Cash Flow
a. $40  1.02 = $40.80 $1,040  1.022 = $1,082.016

b. $40  1.04 = $41.60 $1,040  1.042 = $1,124.864

c. $40  1.06 = $42.40 $1,040  1.062 = $1,168.544

d. $40  1.08 = $43.20 $1,040  1.082 = $1,213.056

Est time: 06–10

28. The coupon bond will fall from an initial price of $1,000 (when yield to maturity = 8%)
to a new price of $897.26 when yield to maturity immediately rises to 9%. This is a
10.27% decline in the bond price.
$1,000
The initial price of the zero-coupon bond is  $99.38.
1.0830
$1,000
The new price of the zero-coupon bond is  $75.37.
1.0930
This is a price decline of 24.16%, far greater than that of the coupon bond.

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The price of the coupon bond is much less sensitive to the change in yield. It seems to
act like a shorter maturity bond. This makes sense: There are many coupon payments
for the 8% bond, most of which come years before the bond’s maturity date. Each
payment may be considered to have its own “maturity date,” which suggests that the
effective maturity of the bond should be measured as some sort of average of the
maturities of all the cash flows paid out by the bond. The zero-coupon bond, by
contrast, makes only one payment at the final maturity date.

Est time: 06–10

29. a., b.
Yield Price A Price B % Diff (8%) % Diff (8%) B
2% 144.93 324.67 165% 124%
3% 119.68 277.14 119% 91%
4% 100.00 239.00 83% 65%
5% 84.55 208.15 54% 43%
6% 72.33 183.00 32% 26%
7% 62.59 162.35 14% 12%
8% 54.76 145.24 0% 0%
9% 48.41 130.95 -12% -10%
10% 43.22 118.92 -21% -18%
11% 38.93 108.72 -29% -25%
12% 35.36 99.99 -35% -31%
13% 32.35 92.48 -41% -36%
14% 29.80 85.95 -46% -41%
15% 27.62 80.25 -50% -45%

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c.

200%

150%

100%

%diff(8%) A
50%
%diff(8%) B

0%
0% 5% 10% 15% 20%

-50%

-100%

The price of bond A is more sensitive to interest rate changes as reflected in the steeper
curve.

d. Bond A has a higher effective maturity (higher duration). A bond that pays a high
coupon rate has a lower effective maturity since a greater proportion of the total return
to the investment is received before maturity. A bond that pays a lower coupon rate has
a longer average time to each payment.

Est time: 11–15

30. a., b.
Cash Flow from PV of Cash
Year YTM Bond Flow
1 4.0% 100 96.15384615
2 5.0% 100 90.70294785
3 5.5% 100 85.16136642
4 5.5% 100 80.72167433
5 5.5% 100 76.51343538
6 6.0% 100 70.49605404
7 6.0% 100 66.50571136
8 6.0% 100 62.74123713
9 6.0% 100 59.18984635
10 6.0% 1100 614.2342546

Bond Price (PV) = 1302.420374

YTM (RATE) = 5.91%

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c. The yield to maturity on the zero-coupon bond is higher. The zero-coupon has a higher
effective maturity (higher duration) in that a greater proportion of the cash flow is
received at the maturity. The zero-coupon bond is therefore more sensitive to changes
in interest rates which are expected to rise based on this upward sloping yield curve.

Est time: 11–15

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