FIN 612 Managerial Finance

Week Five Assignment

Your assignment for this week is to complete the following questions and problems from
Chapter 5. Please submit your complete assignment in the course room by the due date.

Chapter 5 Questions

(5-2) “Short-term interest rates are more volatile than long-term interest rates, so short-term
bond prices are more sensitive to interest rate changes than are long-term bond prices.”
Is this statement true or false? Explain.

False. Short-term bond prices are less sensitive than long-term bond prices to interest rate
changes because funds invested in short-term bonds can be reinvested at the new interest
rate sooner than funds tied up in long-term bonds.

(5-3) The rate of return on a bond held to its maturity date is called the bond’s yield to
maturity.
If interest rates in the economy rise after a bond has been issued, what will happen to the
bond’s price and to its YTM? Does the length of time to maturity affect the extent to which
a given change in interest rates will affect the bond’s price? Why or why not?

The price of the bond will fall and its YTM will rise if interest rates rise. If the bond still
has a long term to maturity, its YTM will reflect long-term rates. Of course, the bond's
price will be less affected by a change in interest rates if it has been outstanding a long time
and matures shortly. While this is true, it should be noted that the YTM will increase only
for buyers who purchase the bond after the change in interest rates and not for buyers who
purchased previous to the change. If the bond is purchased and held to maturity, the
bondholder's YTM will not change, regardless of what happens to interest rates.

(5-4) If you buy a callable bond and interest rates decline, will the value of your bond rise by as
much as it would have risen if the bond had not been callable? Explain.

If interest rates decline significantly, the values of callable bonds will not rise by as much as
those of bonds without the call provision. It is likely that the bonds would be called by the
issuer before maturity, so that the issuer can take advantage of the new, lower rates.

(5-5) A sinking fund can be set up in one of two ways. Discuss the advantages and
disadvantages of each procedure from the viewpoint of both the firm and its bondholders.

From the corporation's viewpoint, one important factor in establishing a sinking fund is
that its own bonds generally have a higher yield than do government bonds; hence, the
company saves more interest by retiring its own bonds than it could earn by buying
government bonds. This factor causes firms to favor the second procedure. Investors also
would prefer the annual retirement procedure if they thought that interest rates were more
likely to rise than to fall, but they would prefer the government bond purchases program if
they thought rates were likely to fall. In addition, bondholders recognize that, under the
government bond purchase scheme, each bondholder would be entitled to a given amount
of cash from the liquidation of the sinking fund if the firm should go into default, whereas
under the annual retirement plan, some of the holders would receive a cash benefit while
others would benefit only indirectly from the fact that there would be fewer bonds
outstanding.
On balance, investors seem to have little reason for choosing one method over the other,
while the annual retirement method is clearly more beneficial to the firm. The
consequence has been a pronounced trend toward annual retirement and away from the
accumulation scheme.

Chapter 5 Problems

(5-1) Jackson Corporation’s bonds have 12 years remaining to maturity. Interest is paid
annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The
bonds have a yield to maturity of 9%. What is the current market price of these bonds?

With your financial calculator, enter the following:

N = 12; I/YR = YTM = 9%; PMT = 0.08  1,000 = 80; FV = 1000; PV = VB = ?

PV = $928.39.

Alternatively,

VB = $80((1- 1/1.0912)/0.09) + $1,000(1/1.0912)

= $928.39

(5-2) Wilson Wonders’s bonds have 12 years remaining to maturity. Interest is paid annually,
the bonds have a $1,000 par value, and the coupon interest rate is 10%. The bonds sell at a
price of $850. What is their yield to maturity?

With your financial calculator, enter the following:

N = 12; PV = -850; PMT = 0.10  1,000 = 100; FV = 1000; I/YR = YTM = ?

YTM = 12.48%.
(5-5) A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has
a yield of 9%. Assume that the liquidity premium on the corporate bond is 0.5%. What is
the default risk premium on the corporate bond?

rT-10 = 6%; rC-10 = 9%; LP = 0.5%; DRP = ?

r = r* + IP + DRP + LP + MRP.

rT-10 = 6% = r* + IP + MRP; DRP = LP = 0.

rC-10 = 8% = r* + IP + DRP + 0.5% + MRP.

Because both bonds are 10-year bonds the inflation premium and maturity risk
premium on both bonds are equal. The only difference between them is the
liquidity and default risk premiums.

rC-10 = 9% = r* + IP + MRP + 0.5% + DRP. But we know from above that r* + IP +

MRP = 6%; therefore,

rC-10 = 9% = 6% + 0.5% + DRP

2.5% = DRP.

(5-6) The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2-
year
Treasury security yields 6.3%. What is the maturity risk premium for the 2-year security?

r* = 3%; IP = 3%; rT-2 = 6.3%; MRP2 = ?

rT-2 = r* + IP + MRP = 6.3%

rT-2 = 3% + 3% + MRP = 6.3%
MRP = 0.3%.

(5-7) Renfro Rentals has issued bonds that have a 10% coupon rate, payable semiannually.
The bonds mature in 8 years, have a face value of $1,000, and a yield to maturity of 8.5%.
What is the price of the bonds?
The problem asks you to find the price of a bond, given the following facts:

N = 16; I/YR = 8.5/2 = 4.25; PMT = 50; FV = 1000.

With a financial calculator, solve for PV = $1,085.80

(5-8) Thatcher Corporation’s bonds will mature in 10 years. The bonds have a face value of
$1,000 and an 8% coupon rate, paid semiannually. The price of the bonds is $1,100.
The bonds are callable in 5 years at a call price of $1,050. What is their yield to maturity?
What is their yield to call?

With your financial calculator, enter the following to find YTM:

N = 10  2 = 20; PV = -1100; PMT = 0.08/2  1,000 = 40; FV = 1000; I/YR = YTM = ?

YTM = 3.31%  2 = 6.62%.

With your financial calculator, enter the following to find YTC:

N = 5  2 = 10; PV = -1100; PMT = 0.08/2  1,000 = 40; FV = 1050; I/YR = YTC = ?

YTC = 3.24%  2 = 6.49%.

(5-10) The Brownstone Corporation’s bonds have 5 years remaining to maturity.

Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest
rate is 9%.
a. What is the yield to maturity at a current market price of (1) $829 or (2) $1,104?
b. Would you pay $829 for one of these bonds if you thought that the appropriate rate
of interest was 12%—that is, if rd = 12%? Explain your answer.

a. Calculator solution:

1. Input N = 5, PV = -829, PMT = 90, FV = 1000, I/YR = ? I/YR = 13.98%.

2. Change PV = -1104, I/YR = ? I/YR = 6.50%.

b. Yes. At a price of $829, the yield to maturity, 13.98 percent, is greater than your
required rate of return of 12 percent. If your required rate of return were 12
percent, you should be willing to buy the bond at any price below $891.86.
 (5-14) A bond that matures in 7 years sells for $1,020. The bond has a face value of $1,000 and
a
yield to maturity of 10.5883%. The bond pays coupons semiannually. What is the bond’s
current yield?

The problem asks you to solve for the current yield, given the following facts: N = 14, I/YR
= 10.5883/2 = 5.2942, PV = −1020, and FV = 1000. In order to solve for the current yield we
need to find PMT. With a financial calculator, we find PMT = $55.00. However, because
the bond is a semiannual coupon bond this amount needs to be multiplied by 2 to obtain the
annual interest payment: $55.00(2) = $110.00. Finally, find the current yield as follows:

Current yield = Annual interest/Current Price = $110/$1,020 = 10.78%.

(5-18) The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year, and
then 3.5% thereafter. The maturity risk premium is estimated to be 0.0005 × (t − 1), where
t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury
security?

r = r* + IP + MRP + DRP + LP.

r* = 0.02.
IP = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035.
MRP = 0.0005(6) = 0.003.
DRP = 0.
LP = 0.

r = 0.02 + 0.035 + 0.003 = 0.058 = 5.8%.

(5-21) Suppose Hillard Manufacturing sold an issue of bonds with a 10-year maturity, a $1,000
par value, a 10% coupon rate, and semiannual interest payments.
a. Two years after the bonds were issued, the going rate of interest on bonds such as
these fell to 6%. At what price would the bonds sell?
b. Suppose that 2 years after the initial offering, the going interest rate had risen to 12%.
At what price would the bonds sell?
c. Suppose that 2 years after the issue date (as in part a) interest rates fell to 6%.
Suppose further that the interest rate remained at 6% for the next 8 years. What
would happen to the price of the bonds over time?
a. The bonds now have an 8-year, or a 16-semiannual period, maturity, and their value
is calculated as follows:

Calculator solution: Input N = 16, I/YR = 3, PMT = 50, FV = 1000,

PV = ? PV = $1,251.22.

b. Calculator solution: Change inputs from Part a to I/YR = 6, PV = ?

PV = $898.94.

c. The price of the bond will decline toward $1,000, hitting $1,000 (plus accrued
interest) at the maturity date 8 years (16 six-month periods) hence.