TUNIS BUSINESS SCHOOL BCOR 260: Principles of Finance - Tutorial

UNIVERSITY OF TUNIS

HOMEWORK 3
Instructions:
Please send your answer in 1 single document in PDF format. Clearly write your full name,
Group, and ID number. Deadline is set for Sunday 8 May, at midnight. Any late submission will
automatically be rejected. Good luck!

Exercise 1:

A firm issued a bond with the following characteristics:

Face Value: $1,000, Semi-annual coupon payments, Coupon rate c: 8%, Market interest
rate rd : 10%
Issue date: 01/01/2015, Maturity date: 01/01/2025

1. Was the bond issued at a discount or at premium? Why?

2. The bondholder decided to sell the bond at 15/09/2020. Find the present value of the
bond at 01/07/2020.
3. Find the Full price at 15/09/2020.
4. Find the Accrued Interest from 01/07/2020 to 15/09/2020.
5. Find the Clean price.

Answer:

1-c < rd means the company is offering less than the market, so the issue is at a discount (Price
< Par).
P Last P Full
2-
01/07/20
01/01/18

01/01/19
01/01/15

01/01/16

01/01/17

15/09/20
01/01/20

01/01/21

01/01/24
01/01/22

01/01/25
01/01/23

The PR of a bond at any date is the present value of the future CFs that come next.
So, PR bond at 01/07/20 is the present value of all the coupon payments that will be paid out
next, starting from 01/01/21 to 01/01/25 in addition to the present value of the Face Value
that will be paid at maturity 01/01/25. We’re talking here about N=4.5 years (9 semesters).
We’re dealing with a semi-annual coupon payments.
r 10% −2∗4.5
C 1−(1+ d )−2∗N FV 80 1−(1+ ) 1000
2 2
PR 01/20 = 2 * ( )+ r = *( )+ 10% 2∗4.5
07 rd /2 (1+ d ) 2∗N 2 10%/2 (1+ )
2 2
c∗FV 8%∗1000
N = 4.5 ; C = 2 = = $40 ; rd = 10% (remember c and rd are always given annually!)
2
PR 01/20 = $928.92
07
(If we’re working on an annual basis, we won’t divide using rd and C by 2 or multiply N by 2)

1
 TUNIS BUSINESS SCHOOL BCOR 260: Principles of Finance - Tutorial
UNIVERSITY OF TUNIS

3-Please note that: The year 2020 is a 366-day year, and we’re using actual/actual to count
days. To find the PR Full at 15/09/20, we now need to compound the PR found in 01/07/20 to
that date:
r 10%
PR Full = PR 07/20*(1 + 2d )t/T = 928.92*(1 + 2 )76/183
01
where t = 76; t= (July + Aug + part of Sept) – 1 = (31+31+15)-1
and T = (July + Aug + Sept + Oct + Nov + Dec) – 1 = (31+31+30+31+30+31)-1= 183
Therefore, PR Full = $947.93
Notice that we’re using 183 days for the second semester, same as any regular year, because
February is in the 1st semester, so we’re not concerned here. If we’re working on an annual
basis, T would be 366 days.
C t
4-Accrued Interest (AI) = 2 * T = $16.61

5-PR Clean = PR Full – AI = 947.93 – 16.61

PR Clean = $931.32

Exercise 2:
Suppose a firm is planning to distribute the following set of dividends in the next 4 years:

𝐷1 = $1; 𝐷2 = $1.3; 𝐷3 = $1.7; 𝐷4 = $2. The dividends will then grow at a constant sustainable
rate.

The required rate of return is 10%, the return on equity is 12%, and the dividend payout ratio
is 0.3.
1. Determine the constant sustainable growth rate in effect after the 4 th year.
2. Determine the estimated stock value at t = 0.
3. Determine the estimated stock values at t=1, 2 and 3.
4. Determine the Dividend yield and Capital gain yield at years 2 and 4.

Answer:

1-g = Retention Rate*ROE = (1-Payout ratio)*ROE = 0.12*(1-0.3) = 8.4%

𝐷1 𝐷2 𝐷3 𝐷4 𝑃4 𝐷5
2-𝑃0 = + + + + with 𝑃4 = and 𝐷5 = 𝐷4 *(1+g)
(1+𝑟)1 (1+𝑟)2 (1+𝑟)3 (1+𝑟)4 (1+𝑟)4 𝑟−𝑔

1 1.3 1.7 2 135.5 2∗(1+0.084)

𝑃0 = (1+0.1)1 + (1+0.1)2 + (1+0.1)3 + (1+0.1)4 + (1+0.1)4 with 𝑃4 = = $135.5
0.1−0.084

𝑃0 = $97.175
2 𝐷 3 𝐷 4 4 𝐷 𝑃 1.3 1.7 2 135.5
3-𝑃1 = (1+𝑟) 1 + (1+𝑟)2 + (1+𝑟)3 + (1+𝑟)3 = (1+0.1)1 + (1+0.1)2 + (1+0.1)3 + (1+0.1)3

𝑃1 = $105.89
3𝐷 4 𝐷 4 𝑃 1.7 2 135.5
𝑃2 = (1+𝑟)1 + (1+𝑟)2 + (1+𝑟)2 = (1+0.1)1 + (1+0.1)2 + (1+0.1)2

2
 TUNIS BUSINESS SCHOOL BCOR 260: Principles of Finance - Tutorial
UNIVERSITY OF TUNIS

𝑃2 = $115.18
4𝐷 4 𝑃 2 135.5
𝑃3 = (1+𝑟)1
+ (1+𝑟)1
= (1+0.1)1 + (1+0.1)1

𝑃3 = $125
𝐷 1.3
4-𝐷𝑌2 = 𝑃2 = 105.89 = 1.228%
1

𝑃2 −𝑃1 115.18−105.89
𝐶𝐺𝑌2 = = = 8.773%
𝑃1 105.89

(Notice that we could’ve calculated 𝐶𝐺𝑌2 = r - 𝐷𝑌2 = 10%-1.228% ≈ 8.773% (don’t worry too
much about the approximation))
𝐷 2
𝐷𝑌4 = 𝑃4 = 125 = 1.6%
3

𝑃4 −𝑃3 135.5−125
𝐶𝐺𝑌4 = = = 8.4%
𝑃3 125

(Again, notice that we could’ve calculated 𝐶𝐺𝑌4 = r - 𝐷𝑌4 = 10%-1.6% ≈ 8.4%)

Exercise 3:
Suppose a semi-annual bond offered at $1,075 with a YTM of 8%, and time left till maturity of
15 years.
1. Intuitively, compare the bond’s annual coupon rate to its YTM. Why?
2. Calculate the bond’s annual coupon rate.
3. Determine the bond’s Current yield 5 years prior to maturity.
4. Determine the bond’s Capital Gain Yield 5 years prior to maturity.
Answer:
1-Bond is issued at a premium. Therefore, the issuer is offering a coupon higher than the
prevailing market interest rate (8%, which happens to be equal to the YTM, because it is
assumed that r is stable!)
𝑌𝑇𝑀 −2∗N
C 1−(1+ ) Par
2
2-𝑃0 = *( )+ YTM
2 YTM/2 (1+ )2∗N
2

8% −2∗15
1,000∗c 1−(1+ ) 1,000
2
1,075= *( )+ 8% ,
2 8%/2 (1+ )2∗15
2

1,000 8%/2
c = (1,075 - 8% )*(2/1,000)* 8% c = 8.867%
(1+ )2∗15 1−(1+ )−2∗15
2 2

𝐶10 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑢𝑝𝑜𝑛 $

3-𝐶𝑌10 = , coupons are constant and CY = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑟𝑖𝑐𝑒
𝑃9

Here, beginning period is beginning of year 10 (or end of year 9, 𝑃9 )

C= 1,000*8.867% = $88.67 (remember that we need ANNUAL coupon to calculate CY!)

3
 TUNIS BUSINESS SCHOOL BCOR 260: Principles of Finance - Tutorial
UNIVERSITY OF TUNIS
8% −2∗6
1,000∗8.867% 1−(1+ ) 1,000
2
𝑃9 = *( )+ 8% = $1,040.68
2 8%/2 (1+ )2∗6
2

Notice that we used N=6: 6 years remaining to maturity (end of year 9 to end of year 15)
88.67
So, 𝐶𝑌10 = = 8.52%
1,040.68
𝑃10 −𝑃9
4-𝐶𝐺𝑌10 =
𝑃9
8% −2∗5
1,000∗8.867% 1−(1+ ) 1,000
2
With 𝑃10 = *( )+ 8% = $1,035.16
2 8%/2 (1+ )2∗5
2

1,035.16−1,040.68
So, 𝐶𝐺𝑌10 = = -0.53%
1,040.68

We expect the CGY to be negative because the bond is issued at a premium. Therefore, as
time passes and we get closer to maturity, prices drop by a certain portion of the premium,
until finally it hits the par value of 1,000 at maturity (Bond is pulled to par, from up top.
Remember the price trajectory of a premium bond!!).

Notice that we could’ve found the 𝐶𝐺𝑌10 using the relationship: YTM = CGY + CY (this is easier in
the exam)

YTM is constant = 8%. 𝐶𝑌10 = 8.522%. 𝐶𝐺𝑌10 = YTM - 𝐶𝑌10 = 8% - 8.52% = -0.52% (almost the same,
small difference due to the approximations. Don’t worry about it so much).

Exercise 4:
Suppose a 15-year Callable bond, 8% semi-annual coupon bond, with a remaining maturity of
10 years, priced at $925. The bond can be called backed by the issuer, based on the following
schedule: 7th year, 10th year, and 12th year, since inception (since creation of the bond). The
call price is set at $1,025. The interest rates in the market are expected to rise in the near
future.

1. Determine the YTM of the Callable bond.

2. Determine the YTC of the Callable bond, if we suppose the bond can be called 7 years
after its inception (issue).
3. Which rate the investor should expect to earn based on the market interest rate
forecasting?
Answer:
𝑌𝑇𝑀 −2∗N 𝑌𝑇𝑀 −2∗10
C 1−(1+ ) Par 1,000∗8% 1−(1+ ) 1,000
2 2
1-𝑃0 = *( )+ YTM = *( )+ YTM
2 YTM/2 (1+ )2∗N 2 YTM/2 (1+ )2∗10
2 2

Notice that the time to maturity is 10 years, not 15 years (15 years refer to bond’s life since
creation. Be careful here!).

4
 TUNIS BUSINESS SCHOOL BCOR 260: Principles of Finance - Tutorial
UNIVERSITY OF TUNIS

𝑌𝑇𝑀
Suppose X =
2
4% $1,000 1,000∗8% 1−(1+5%)−2∗10 1,000
X $925 *( )+ = $875.378
2 5% (1+5%)2∗10
5% $875.378
X−4% 925−1,000
= X = 4.602% (=4.5806% if using financial calculator)
5%−4% 875.378−1,000
YTM = 2*4.602% = 9.204% (Annual)
Notice that YTM > c%, because bond was issued with a discount

𝑌𝑇𝐶 −2∗n 𝑌𝑇𝐶 −2∗2

C 1−(1+ ) Call Price 1,000∗8% 1−(1+ ) 1,025
2 2
2-𝑃0 = *( )+ YTC = *( )+ YTC
2 YTC/2 (1+ )2∗n 2 YTC/2 (1+ )2∗2
2 2

𝑌𝑇𝐶
Suppose X = 1,000∗8% 1−(1+4%)−2∗2 1,025
2 *( )+ = $1021.370
2 4% (1+4%)2∗2
4% $1,021.370
X $925 1,000∗8% 1−(1+7%)−2∗2 1,025
7% $917.456 *( )+ = $917.456
2 7% (1+7%)2∗2
X−4% 925−1,021.370
= X = 6.782% (=6.7676% if using financial calculator)
7%−4% 917.456−1,021.370
YTC = 2*6.782% = 13.564% (Annual)
3-r is expected to grow, therefore, the issuer most likely won’t call the bond. Higher interest
rates do not encourage refinancing their bond. They only call the bond if r falls, thus financing
becomes cheaper. In addition, notice that the bond was issued at a discount c<r (8%<9.204%).
That’s already considered a deep discount. Recall that if bond is at deep discount, the call is
less likely to occur. Issuer is already in a good position (offers lower rates than the market c<r).
Therefore, the investor should expect the bond to remain until maturity and that he’s most
likely going to earn the YTM, not the YTC.