CH 5 Bonds Book Questions

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Some of the key takeaways from the document include how a bond's price is affected by changes in interest rates, the relationship between bond prices, yields and coupon rates, and how to calculate various bond yields.

One way to set up a sinking fund is for the firm to make periodic contributions to a separate account dedicated to repaying the bonds. The other is for the firm to use cash flows from operations to repay bonds. The main advantage for the firm in the first approach is certainty in repayment schedule while the second provides more flexibility. Bondholders prefer the separate sinking fund for security of repayment.

Factors that affect a company's bond rating include financial ratios like debt to equity and profitability, size and diversification of the firm, management quality, and outlook for the industry.

226 Part 2 Fixed Income Securities

(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?
(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.
(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.

SELF-TEST PROBLEM Solution Appears in Appendix A

(ST-1) The Pennington Corporation issued a new series of bonds on January 1, 1990. The bonds
Bond Valuation were sold at par ($1,000), had a 12% coupon, and matured in 30 years on December 31,
2019. Coupon payments are made semiannually (on June 30 and December 31).
a. What was the YTM on the date the bonds were issued?
b. What was the price of the bonds on January 1, 1995 (5 years later), assuming that
interest rates had fallen to 10%?
c. Find the current yield, capital gains yield, and total yield on January 1, 1995, given
the price as determined in part b.
d. On July 1, 2013 (6.5 years before maturity), Pennington’s bonds sold for $916.42.
What are the YTM, the current yield, and the capital gains yield for that date?
e. Now assume that you plan to purchase an outstanding Pennington bond on March 1,
2013, when the going rate of interest given its risk is 15.5%. How large a check must
you write to complete the transaction? (Hint: Don’t forget the accrued interest.)

PROBLEMS Answers Appear in Appendix B

Easy Problems 1–6


(5-1) Jackson Corporation’s bonds have 12 years remaining to maturity. Interest is paid
Bond Valuation with annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The
Annual Payments bonds have a yield to maturity of 9%. What is the current market price of these bonds?
(5-2) Wilson Wonders’s bonds have 12 years remaining to maturity. Interest is paid annually,
Yield to Maturity for the bonds have a $1,000 par value, and the coupon interest rate is 10%. The bonds sell at a
Annual Payments price of $850. What is their yield to maturity?
(5-3) Heath Foods’s bonds have 7 years remaining to maturity. The bonds have a face value of
Current Yield for $1,000 and a yield to maturity of 8%. They pay interest annually and have a 9% coupon
Annual Payments rate. What is their current yield?
(5-4) The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4%
Determinant of during the next 2 years. Assume that the maturity risk premium is zero. What is the yield
Interest Rates on 2-year Treasury securities? What is the yield on 3-year Treasury securities?
(5-5) A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has
Default Risk a yield of 9%. Assume that the liquidity premium on the corporate bond is 0.5%. What is
Premium the default risk premium on the corporate bond?
(5-6) The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2-year
Maturity Risk Treasury security yields 6.3%. What is the maturity risk premium for the 2-year security?
Premium

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Chapter 5 Bond, Bond Valuation, and Interest Rates 227

Intermediate
Problems 7–20

(5-7) Renfro Rentals has issued bonds that have a 10% coupon rate, payable semiannually.
Bond Valuation with The bonds mature in 8 years, have a face value of $1,000, and a yield to maturity of 8.5%.
Semiannual What is the price of the bonds?
Payments

(5-8) Thatcher Corporation’s bonds will mature in 10 years. The bonds have a face value of
Yield to Maturity and $1,000 and an 8% coupon rate, paid semiannually. The price of the bonds is $1,100.
Call with Semiannual The bonds are callable in 5 years at a call price of $1,050. What is their yield to maturity?
Payments What is their yield to call?
(5-9) The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual
Bond Valuation and interest plus $1,000 at maturity. Bond L has a maturity of 15 years, and Bond S has a
Interest Rate Risk maturity of 1 year.
a. What will be the value of each of these bonds when the going rate of interest is (1)
5%, (2) 8%, and (3) 12%? Assume that there is only one more interest payment to be
made on Bond S.
b. Why does the longer-term (15-year) bond fluctuate more when interest rates change
than does the shorter-term bond (1 year)?

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


Yield to Maturity and
(5-10) Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest
Required Returns rate is 9%.
Yield to Maturity and
Required Returns
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.

(5-11) Seven years ago, Goodwynn & Wolf Incorporated sold a 20-year bond issue with a 14%
Yield to Call and
(5-11) annual coupon rate and a 9% call premium. Today, G&W called the bonds. The bonds
Realized Rates
Yield to Call of
and originally were sold at their face value of $1,000. Compute the realized rate of return for
Return
Realized Rates of investors who purchased the bonds when they were issued and who surrender them today
Return in exchange for the call price.
(5-12)
(5-12) A 10-year, 12% semiannual coupon bond with a par value of $1,000 may be called in
Bond
Bond Yields
Yields and
and 4 years at a call price of $1,060. The bond sells for $1,100. (Assume that the bond has
Rates
Rates of
of Return
Return just been issued.)
a. What is the bond’s yield to maturity?
b. What is the bond’s current yield?
c. What is the bond’s capital gain or loss yield?
d. What is the bond’s yield to call?

(5-13)
(5-13) You just purchased a bond that matures in 5 years. The bond has a face value of $1,000
Yield
Yield to
to Maturity
Maturity and
and and has an 8% annual coupon. The bond has a current yield of 8.21%. What is the bond’s
Current
Current Yield
Yield yield to maturity?
(5-14)
(5-14) A bond that matures in 7 years sells for $1,020. The bond has a face value of $1,000 and a
Current
Current Yield
Yield with
with yield to maturity of 10.5883%. The bond pays coupons semiannually. What is the bond’s
Semiannual
Semiannual current yield?
Payments
Payments

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228 Part 2 Fixed Income Securities

(5-15) Absalom Motors’s 14% coupon rate, semiannual payment, $1,000 par value bonds that
Yield to Call, Yield to mature in 30 years are callable 5 years from now at a price of $1,050. The bonds sell at a
Maturity, and Market price of $1,353.54, and the yield curve is flat. Assuming that interest rates in the economy
Rates are expected to remain at their current level, what is the best estimate of the nominal
interest rate on new bonds?
(5-16) A bond trader purchased each of the following bonds at a yield to maturity of 8%.
Interest Rate Immediately after she purchased the bonds, interest rates fell to 7%. What is the
Sensitivity percentage change in the price of each bond after the decline in interest rates? Fill in
the following table:

Price @ 8% Price @ 7% Percentage Change


10-year, 10% annual coupon
10-year zero
5-year zero
30-year zero
$100 perpetuity

(5-17) An investor has two bonds in his portfolio. Each bond matures in 4 years, has a face value
Bond Value as of $1,000, and has a yield to maturity equal to 9.6%. One bond, Bond C, pays an annual
Maturity Approaches coupon of 10%; the other bond, Bond Z, is a zero coupon bond. Assuming that the yield
to maturity of each bond remains at 9.6% over the next 4 years, what will be the price of
each of the bonds at the following time periods? Fill in the following table:

t Price of Bond C Price of Bond Z


0
1
2
3
4

(5-18) The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year, and
Determinants of then 3.5% thereafter. The maturity risk premium is estimated to be 0.0005 × (t − 1), where
Interest Rates t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury
security?
(5-19) Assume that the real risk-free rate, r*, is 3% and that inflation is expected to be 8% in
Maturity Risk Year 1, 5% in Year 2, and 4% thereafter. Assume also that all Treasury securities are highly
Premiums liquid and free of default risk. If 2-year and 5-year Treasury notes both yield 10%, what is
the difference in the maturity risk premiums (MRPs) on the two notes; that is, what is
MRP5 minus MRP2?

(5-20) Because of a recession, the inflation rate expected for the coming year is only 3%.
Inflation Risk However, the inflation rate in Year 2 and thereafter is expected to be constant at some
Premiums level above 3%. Assume that the real risk-free rate is r* = 2% for all maturities and that
there are no maturity premiums. If 3-year Treasury notes yield 2 percentage points more
than 1-year notes, what inflation rate is expected after Year 1?

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Chapter 5 Bond, Bond Valuation, and Interest Rates 229

Challenging
Problems 21–23

(5-21) Suppose Hillard Manufacturing sold an issue of bonds with a 10-year maturity, a $1,000
Bond Valuation and par value, a 10% coupon rate, and semiannual interest payments.
Changes in Maturity
and Required
a. Two years after the bonds were issued, the going rate of interest on bonds such as
Returns 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?

(5-22) Arnot International’s bonds have a current market price of $1,200. The bonds have an
Yield to Maturity and 11% annual coupon payment, a $1,000 face value, and 10 years left until maturity.
Yield to Call The bonds may be called in 5 years at 109% of face value (call price = $1,090).
a. What is the yield to maturity?
b. What is the yield to call if they are called in 5 years?
c. Which yield might investors expect to earn on these bonds, and why?
d. The bond’s indenture indicates that the call provision gives the firm the right to call
them at the end of each year beginning in Year 5. In Year 5, they may be called at
109% of face value, but in each of the next 4 years the call percentage will decline by
1 percentage point. Thus, in Year 6 they may be called at 108% of face value, in Year 7
they may be called at 107% of face value, and so on. If the yield curve is horizontal and
interest rates remain at their current level, when is the latest that investors might
expect the firm to call the bonds?

(5-23) Suppose you and most other investors expect the inflation rate to be 7% next year, to fall
Determinants of to 5% during the following year, and then to remain at a rate of 3% thereafter. Assume
Interest Rates that the real risk-free rate, r*, will remain at 2% and that maturity risk premiums on
Treasury securities rise from zero on very short-term securities (those that mature in a
few days) to a level of 0.2 percentage points for 1-year securities. Furthermore, maturity
risk premiums increase 0.2 percentage points for each year to maturity, up to a limit of
1.0 percentage point on 5-year or longer-term T-notes and T-bonds.
a. Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury securities,
and plot the yield curve.
b. Now suppose ExxonMobil’s bonds, rated AAA, have the same maturities as the
Treasury bonds. As an approximation, plot an ExxonMobil yield curve on the same
graph with the Treasury bond yield curve. (Hint: Think about the default risk
premium on ExxonMobil’s long-term versus short-term bonds.)
c. Now plot the approximate yield curve of Long Island Lighting Company, a risky
nuclear utility.

SPREADSHEET PROBLEMS

(5-24) Start with the partial model in the file Ch05 P24 Build a Model.xls on the textbook’s Web
Build a Model: Bond site. A 20-year, 8% semiannual coupon bond with a par value of $1,000 may be called in 5
Valuation years at a call price of $1,040. The bond sells for $1,100. (Assume that the bond has just
been issued.)

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230 Part 2 Fixed Income Securities

a. What is the bond’s yield to maturity?


resource b. What is the bond’s current yield?
c. What is the bond’s capital gain or loss yield?
d. What is the bond’s yield to call?
e. How would the price of the bond be affected by a change in the going market interest
rate? (Hint: Conduct a sensitivity analysis of price to changes in the going market
interest rate for the bond. Assume that the bond will be called if and only if the going
rate of interest falls below the coupon rate. This is an oversimplification, but assume
it for purposes of this problem.)
f. Now assume the date is October 25, 2014. Assume further that a 12%, 10-year bond
was issued on July 1, 2014, pays interest semiannually (on January 1 and July 1), and
sells for $1,100. Use your spreadsheet to find the bond’s yield.

MINI CASE
Sam Strother and Shawna Tibbs are vice presidents of Mutual of Seattle Insurance
Company and co-directors of the company’s pension fund management division. An
important new client, the North-Western Municipal Alliance, has requested that Mutual
of Seattle present an investment seminar to the mayors of the represented cities, and
Strother and Tibbs, who will make the actual presentation, have asked you to help them
by answering the following questions.
a. What are the key features of a bond?
b. What are call provisions and sinking fund provisions? Do these provisions make
bonds more or less risky?
c. How does one determine the value of any asset whose value is based on expected
future cash flows?
d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par
value bond with a 10% annual coupon if its required rate of return is 10%?
e. (1) What would be the value of the bond described in part d if, just after it had been
issued, the expected inflation rate rose by 3 percentage points, causing investors
to require a 13% return? Would we now have a discount or a premium bond?
(2) What would happen to the bond’s value if inflation fell and rd declined to 7%?
Would we now have a premium or a discount bond?
(3) What would happen to the value of the 10-year bond over time if the required
rate of return remained at 13%? If it remained at 7%? (Hint: With a financial
calculator, enter PMT, I/YR, FV, and N, and then change N to see what happens
to the PV as the bond 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 a
bond sells at a discount or at a premium tell you about the relationship between
rd and the bond’s coupon rate?
(2) What are the total return, the current yield, and the capital gains yield for the
discount bond? (Assume the bond is held to maturity and the company does not
default on the bond.)
g. 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 the nominal
rd = 13%.

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Chapter 5 Bond, Bond Valuation, and Interest Rates 231

h. 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, the bond can be called after 5 years for a price of $1,050.
(1) What is the bond’s nominal yield to call (YTC)?
(2) If you bought this bond, do you think you would be more likely to earn the YTM
or the YTC? Why?
i. Write a general expression for the yield on any debt security (rd) and define these
terms: real risk-free rate of interest (r*), inflation premium (IP), default risk
premium (DRP), liquidity premium (LP), and maturity risk premium (MRP).
j. Define the nominal risk-free rate (rRF). What security can be used as an estimate of rRF?
k. Describe a way to estimate the inflation premium (IP) for a t-year bond.
l. What is a bond spread and how is it related to the default risk premium? How are
bond ratings related to default risk? What factors affect a company’s bond rating?
m. What is interest rate (or price) risk? Which bond has more interest rate risk: an
annual payment 1-year bond or a 10-year bond? Why?
n. What is reinvestment rate risk? Which has more reinvestment rate risk: a 1-year
bond or a 10-year bond?
o. How are interest rate risk and reinvestment rate risk related to the maturity risk
premium?
p. What is the term structure of interest rates? What is a yield curve?
q. Briefly describe bankruptcy law. If a firm were to default on its bonds, would the
company be liquidated immediately? Would the bondholders be assured of receiving
all of their promised payments?

SELECTED ADDITIONAL CASES


The following cases from CengageCompose cover many of the concepts discussed in this
chapter and are available at compose.cengage.com.
Klein-Brigham Series:
Case 3, “Peachtree Securities, Inc. (B)”; Case 72, “Swan Davis”; and Case 78, “Beatrice
Peabody.”
Brigham-Buzzard Series:
Case 3, “Powerline Network Corporation (Bonds and Preferred Stock).”

Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

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