DISCOUNTED CASH FLOW VALUATION
64. Refundable fee: With the $1,500 application fee, you will need to borrow $201,500 to have
$200,000 after deducting the fee. Solve for the payment under these circumstances.
Enter 30 × 12 7.50% / 12 $201,500
N I/Y PV PMT FV
Solve for $1,408.92
Enter 30 × 12 $200,000 ±$1,408.92
N I/Y PV PMT FV
Solve for 0.6314%
APR = 0.6314% × 12 = 7.58%
Enter 7.58% 12
NOM EFF C/Y
Solve for 7.85%
Without refundable fee: APR = 7.50%
Enter 7.50% 12
NOM EFF C/Y
Solve for 7.76%
65.
Enter 36 £1,000 ±£42.25
N I/Y PV PMT FV
Solve for 2.47%
APR = 2.47% × 12 = 29.63%
Enter 29.63% 12
NOM EFF C/Y
Solve for 34.00%
66. What she needs at age 65:
Enter 15 8% $90,000
N I/Y PV PMT FV
Solve for $770,353.08
a.
Enter 30 8% $770,353.08
N I/Y PV PMT FV
Solve for $6,800.24
b.
Enter 30 8% $770,353.08
N I/Y PV PMT FV
Solve for $76,555.63
c.
Enter 10 8% $25,000
N I/Y PV PMT FV
Solve for $53,973.12
At 65, she is short: $770,353.08 – 53,973.12 = $716,379.96
Enter 30 8% ±$716,379.96
N I/Y PV PMT FV
Solve for $6,323.80
Her employer will contribute $1,500 per year, so she must contribute:
$6,323.80 – 1,500 = $4,823.80 per year 67. Without fee:
Enter 19.2% / 12 £10,000 ±£200
N I/Y PV PMT FV
Solve for 101.39
Enter 9.2% / 12 £10,000 ±£200
N I/Y PV PMT FV
Solve for 63.30 With fee:
Enter 9.2% / 12 £10,200 ±£200
N I/Y PV PMT FV
Solve for 64.94 68. Value at Year 6:
Enter 5 11% €750
N I/Y PV PMT FV
Solve for €1,263.79
Enter 4 11% €750
N I/Y PV PMT FV
Solve for €1,138.55
Enter 3 11% €850
N I/Y PV PMT FV
Solve for €1,162.49
Enter 2 11% €850
N I/Y PV PMT FV
Solve for €1,047.29
Enter 1 11% €950
N I/Y PV PMT FV
Solve for €1,054.50
So, at Year 5, the value is: €1,263.79 + 1,138.55 + 1,162.49 + 1,047.29 + 1,054.50 + 950 = €6,612.62
At Year 65, the value is:
Enter 59 7% €6,612.62
N I/Y PV PMT FV
Solve for €358,326.50
The policy is not worth buying; the future value of the policy is €358K, but the policy contract will pay off €250K.
69. Effective six-month rate = (1 + Daily rate)180 – 1 Effective six-month rate = (1 + .09/365)180 – 1 Effective six-month rate = .0454 or 4.54%
Enter 40 4.54% R$500,000
N I/Y PV PMT FV
Solve for R$9,151,418.61
Enter 1 4.54% R$9,089,929.35
N I/Y PV PMT FV
Solve for R$8,754,175.76
Value of winnings today = R$8,754,175.76 + 1,000,000 Value of winnings today = R$9,754,175.76
70.
CFo ±$8,000 C01 ±$8,000 F01 5 C02 $20,000 F02 4 IRR CPT 10.57%
74. The value at t = 7:
Enter 6 10% £75,000
N I/Y PV PMT FV
Solve for £132,867.08
Enter 10 10% £132,867.08
N I/Y PV PMT FV
Solve for £21,623.50
75.
a. APR = 10% × 52 = 520%
Enter 520% 52
NOM EFF C/Y
Solve for 14,104.29%
b.
Enter 1 Rs.9.00 ±Rs.10.00
N I/Y PV PMT FV
Solve for 11.11%
APR = 11.11% × 52 = 577.78%
Enter 577.78% 52
NOM EFF C/Y
Solve for 23,854.63%
c.
Enter 4 Rs.588.40 ±Rs.250
N I/Y PV PMT FV
Solve for 25.19%
APR = 25.19% × 52 = 1,309.92%
Enter 1,309.92 % 52
NOM EFF C/Y
Solve for 11,851,501.94%
CHAPTER 5
INTEREST RATES AND BOND VALUATION
Answers to Concepts Review and Critical Thinking Questions
1. No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury securities have substantial interest rate risk.
2. All else the same, the Treasury security will have lower coupons because of its lower default risk, so it will have greater interest rate risk.
3. No. If the bid were higher than the ask, the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price. How many such transactions would you like to do?
4. Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must be higher.
5. There are two benefits. First, the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue. Second, a company might wish to
eliminate a covenant for some reason. Calling the issue does this. The cost to the company is a higher coupon. A put provision is desirable from an investor’s standpoint, so it helps the company by reducing the coupon rate on the bond. The cost to the company is that it may have to buy back the bond at an unattractive price.
6. Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are used to establish the coupon rate necessary for a particular issue to initially sell for par value.
Bond issuers also simply ask potential purchasers what coupon rate would be necessary to attract them. The coupon rate is fixed and simply determines what the bond’s coupon payments will be.
The required return is what investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required return are equal only if the bond sells for exactly at par.
7. Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal.
Their primary concern is that an investment provides the needed nominal dollar amounts. Pension funds, for example, often must plan for pension payments many years in the future. If those payments are fixed in dollar terms, then it is the nominal return on an investment that is important.
8. Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell;
many large investors are prohibited from investing in unrated issues.
9. Treasury bonds have no credit risk since it is backed by the U.S. government, so a rating is not necessary. Junk bonds often are not rated because there would be no point in an issuer paying a rating agency to assign its bonds a low rating (it’s like paying someone to kick you!).
10. The term structure is based on pure discount bonds. The yield curve is based on coupon-bearing issues.
11. Bond ratings have a subjective factor to them. Split ratings reflect a difference of opinion among credit agencies.
12. As a general constitutional principle, the federal government cannot tax the states without their consent if doing so would interfere with state government functions. At one time, this principle was thought to provide for the tax-exempt status of municipal interest payments. However, modern court rulings make it clear that Congress can revoke the municipal exemption, so the only basis now appears to be historical precedent. The fact that the states and the federal government do not tax each other’s securities is referred to as “reciprocal immunity.”
13. Lack of transparency means that a buyer or seller can’t see recent transactions, so it is much harder to determine what the best bid and ask prices are at any point in time.
14. One measure of liquidity is the bid-ask spread. Liquid instruments have relatively small spreads.
Looking at Figure 7.4, the bellwether bond has a spread of one tick; it is one of the most liquid of all investments. Generally, liquidity declines after a bond is issued. Some older bonds, including some of the callable issues, have spreads as wide as six ticks.
15. Companies charge that bond rating agencies are pressuring them to pay for bond ratings. When a company pays for a rating, it has the opportunity to make its case for a particular rating. With an unsolicited rating, the company has no input.
16. A 100-year bond looks like a share of preferred stock. In particular, it is a loan with a life that almost certainly exceeds the life of the lender, assuming that the lender is an individual. With a junk bond, the credit risk can be so high that the borrower is almost certain to default, meaning that the creditors are very likely to end up as part owners of the business. In both cases, the
“equity in disguise” has a significant tax advantage.
17. a. The bond price is the present value of the cash flows from a bond. The YTM is the interest rate used in valuing the cash flows from a bond.
b. If the coupon rate is higher than the required return on a bond, the bond will sell at a premium, since it provides periodic income in the form of coupon payments in excess of that required by investors on other similar bonds. If the coupon rate is lower than the required return on a bond, the bond will sell at a discount since it provides insufficient coupon payments compared to that required by investors on other similar bonds. For premium bonds, the coupon rate exceeds the YTM; for discount bonds, the YTM exceeds the coupon rate, and for bonds selling at par, the YTM is equal to the coupon rate.
c. Current yield is defined as the annual coupon payment divided by the current bond price. For premium bonds, the current yield exceeds the YTM, for discount bonds the current yield is less than the
YTM, and for bonds selling at par value, the current yield is equal to the YTM. In all cases, the current yield plus the expected one-period capital gains yield of the bond must be equal to the required return.
18. A long-term bond has more interest rate risk compared to a short-term bond, all else the same. A low coupon bond has more interest rate risk than a high coupon bond, all else the same. When comparing a high coupon, long-term bond to a low coupon, short-term bond, we are unsure which has more interest rate risk. Generally, the maturity of a bond is a more important determinant of the interest rate risk, so the long-term high coupon bond probably has more interest rate risk. The exception would be if the maturities are close, and the coupon rates are vastly different.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.
NOTE: Most problems do not explicitly list a par value for bonds. Even though a bond can have any par value, in general, corporate bonds in the United States will have a par value of $1,000. We will use this par value in all problems unless a different par value is explicitly stated.
Basic
1. The price of a pure discount (zero coupon) bond is the present value of the par. Even though the bond makes no coupon payments, the present value is found using semiannual compounding periods, consistent with coupon bonds. This is a bond pricing convention. So, the price of the bond for each YTM is:
a. P = €1,000/(1 + .03)20 = €553.68 b. P = €1,000/(1 + .05)20 = €376.89 c. P = €1,000/(1 + .07)20 = €258.42
2. The price of any bond is the PV of the interest payment, plus the PV of the par value. Notice this problem assumes an annual coupon. The price of the bond at each YTM will be:
a. P = £40({1 – [1/(1 + .04)]40 } / .04) + £1,000[1 / (1 + .04)40] P = £1,000.00
When the YTM and the coupon rate are equal, the bond will sell at par.
b. P = £40({1 – [1/(1 + .05)]40 } / .05) + £1,000[1 / (1 + .05)40] P = £828.41
When the YTM is greater than the coupon rate, the bond will sell at a discount.
c. P = £40({1 – [1/(1 + .03)]40 } / .03) + £1,000[1 / (1 + .03)40] P = £1,231.15
When the YTM is less than the coupon rate, the bond will sell at a premium.
We would like to introduce shorthand notation here. Rather than write (or type, as the case may be) the entire equation for the PV of a lump sum, or the PVA equation, it is common to abbreviate the equations as:
PVIFR,t = 1 / (1 + r)t
which stands for Present Value Interest Factor PVIFAR,t = ({1 – [1/(1 + r)]t } / r )
which stands for Present Value Interest Factor of an Annuity
These abbreviations are short hand notation for the equations in which the interest rate and the number of periods are substituted into the equation and solved. We will use this shorthand notation in remainder of the solutions key.
3. Here we are finding the YTM of a semiannual coupon bond. The bond price equation is:
P = 元 970 = 元 43(PVIFAR%,20) + 元 1,000(PVIFR%,20)
Since we cannot solve the equation directly for R, using a spreadsheet, a financial calculator, or trial and error, we find:
R = 4.531%
Since the coupon payments are semiannual, this is the semiannual interest rate. The YTM is the APR of the bond, so:
YTM = 2 ×4.531% = 9.06%
4. Here we need to find the coupon rate of the bond. All we need to do is to set up the bond pricing equation and solve for the coupon payment as follows:
P = $1,145 = C(PVIFA3.75%,29) + $1,000(PVIF3.75%,29) Solving for the coupon payment, we get:
C = $45.79
Since this is the semiannual payment, the annual coupon payment is:
2 × $45.79 = $91.58
And the coupon rate is the coupon rate divided by par value, so:
Coupon rate = $91.58 / $1,000 = 9.16%
5. The approximate relationship between nominal interest rates (R), real interest rates (r), and inflation (h) is:
R = r + h
Approximate r = .06 –.045 =.015 or 1.50%
The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is:
(1 + R) = (1 + r)(1 + h) (1 + .06) = (1 + r)(1 + .045)
Exact r = [(1 + .06) / (1 + .045)] – 1 = .0144 or 1.44%
6. The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is:
(1 + R) = (1 + r)(1 + h)
R = (1 + .04)(1 + .025) – 1 = .0660 or 6.60%
7. The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is:
(1 + R) = (1 + r)(1 + h)
h = [(1 + .15) / (1 + .09)] – 1 = .0550 or 5.50%
8. The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is:
(1 + R) = (1 + r)(1 + h)
r = [(1 + .134) / (1.045)] – 1 = .0852 or 8.52%
9. This is a bond since the maturity is greater than 10 years. The coupon rate, located in the first column of the quote is 6.125%. The bid price is:
Bid price = 116:05 = 116 5/32 = 116.15625%×$1,000 = $1,161.5625 The previous day’s ask price is found by:
Previous day’s asked price = Today’s asked price – Change = 116 5/32 – (–932) = 116 14/32 The previous day’s price in dollars was:
Previous day’s dollar price = 116.4375%×$1,000 = $1,164.375
10. This is a premium bond because it sells for more than 100% of face value. The current yield is:
Current yield = Annual coupon payment / Price = $75/$1,320.9375 = 5.68%
The YTM is located under the “ASK YLD” column, so the YTM is 4.93%.
The bid-ask spread is the difference between the bid price and the ask price, so:
Bid-Ask spread = 132:03 – 132:02 = 1/32 Intermediate
11. Here we are finding the YTM of semiannual coupon bonds for various maturity lengths. The bond price equation is:
P = C(PVIFAR%,t) + £1,000(PVIFR%,t) Miller Corporation bond:
P0 = £40(PVIFA3%,26) + £1,000(PVIF3%,26) = £1,178.77 P1 = £40(PVIFA3%,24) + £1,000(PVIF3%,24) = £1,169.36 P3 = £40(PVIFA3%,20) + £1,000(PVIF3%,20) = £1,148.77 P7 = £40(PVIFA3%,12) + £1,000(PVIF3%,12) = £1,099.54 P12 = £40(PVIFA3%,2) + £1,000(PVIF3%,2) = £1,019.13 P13 = £1,000
Modigliani Company bond:
Y: P0 = £30(PVIFA4%,26) + £1,000(PVIF4%,26) = £840.17 P1 = £30(PVIFA4%,24) + £1,000(PVIF4%,24) = £847.53 P3 = £30(PVIFA4%,20) + £1,000(PVIF4%,20) = £864.10 P7 = £30(PVIFA4%,12) + £1,000(PVIF4%,12) = £906.15 P12 = £30(PVIFA4%,2) + £1,000(PVIF4%,2) = £981.14 P13 = £1,000
All else held equal, the premium over par value for a premium bond declines as maturity
approaches, and the discount from par value for a discount bond declines as maturity approaches. This is called “pull to par.” In both cases, the largest percentage price changes occur at the shortest maturity lengths.
Also, notice that the price of each bond when no time is left to maturity is the par value, even though the purchaser would receive the par value plus the coupon payment immediately. This is because we calculate the clean price of the bond.
12. Any bond that sells at par has a YTM equal to the coupon rate. Both bonds sell at par, so the initial YTM on both bonds is the coupon rate, 10 percent. If the YTM suddenly rises to 12 percent:
PEvans = €50(PVIFA6%,4) + €1,000(PVIF6%,4) = €965.35 PTroxel = €50(PVIFA6%,30) + €1,000(PVIF6%,30) = €862.35
The percentage change in price is calculated as:
Percentage change in price = (New price – Original price) / Original price
∆PEvans% = (€965.35 – 1,000) / €1,000 = – 3.47%
∆PTroxel% = (€862.35 – 1,000) / €1,000 = – 13.76%
If the YTM suddenly falls to 8 percent:
PEvans = €50(PVIFA4%,4) + €1,000(PVIF4%,4) = €1,036.30 PTroxel = €50(PVIFA4%,30) + €1,000(PVIF4%,30) = €1,172.92
∆PEvans% = (€1,036.30 – 1,000) / €1,000 = + 3.63%
∆PTroxel% = (€1,172.92 – 1,000) / €1,000 = + 17.29%
All else the same, the longer the maturity of a bond, the greater is its price sensitivity to changes in interest rates.
13. Initially, at a YTM of 7 percent, the prices of the two bonds are:
PBusan = 25(PVIFA3.5%,16) + 1,000(PVIF3.5%,16) = 879.06 PIksan = 55(PVIFA3.5%,16) + 1,000(PVIF3.5%,16) = 1,241.88 If the YTM rises from 7 percent to 9 percent:
PBusan = 25(PVIFA4.5%,16) + 1,000(PVIF4.5%,16) = 775.32 PIksan = 55(PVIFA4.5%,16) + 1,000(PVIF4.5%,16) = 1,112.34 The percentage change in price is calculated as:
Percentage change in price = (New price – Original price) / Original price
∆PBusan% = (775.32 – 879.06) / 879.06 = – 11.80%
∆PIksan% = (1,112.34 – 1,241.88) / 1,241.88 = – 10.43%
If the YTM declines from 7 percent to 5 percent:
PBusan = 25(PVIFA2.5%,16) + 1,000(PVIF2.5%,16) = 1,000.000 PIksan = 55(PVIFA2.5%,16) + 1,000(PVIF2.5%,16) = 1,391.65
∆PBusan% = (1,000.00 – 879.06) / 879.06 = + 13.76%
∆PIksan% = (1,391.65 – 1,241.88) / 1,241.88 = + 12.06%
All else the same, the lower the coupon rate on a bond, the greater is its price sensitivity to changes in interest rates.
14. The bond price equation for this bond is:
P0 = $1,040 = $45(PVIFAR%,18) + $1,000(PVIFR%,18)
Using a spreadsheet, financial calculator, or trial and error we find:
R = 4.179%
This is the semiannual interest rate, so the YTM is:
YTM = 2 × 4.179% = 8.359%
The current yield is:
Current yield = Annual coupon payment / Price = $90 / $1,040 = 8.65%
The effective annual yield is the same as the EAR, so using the EAR equation from the previous chapter:
Effective annual yield = (1 + 0.04179)2 – 1 = 8.532%
15. The company should set the coupon rate on its new bonds equal to the required return. The required return can be observed in the market by finding the YTM on outstanding bonds of the company.
So, the YTM on the bonds currently sold in the market is:
P = 元 1,100 = 元 40(PVIFAR%,40) + 元 1,000(PVIFR%,40)
Using a spreadsheet, financial calculator, or trial and error we find:
R = 3.5295%
This is the semiannual interest rate, so the YTM is:
YTM = 2 × 3.5295% = 7.059%
16. Accrued interest is the coupon payment for the period times the fraction of the period that has passed since the last coupon payment. Since we have a semiannual coupon bond, the coupon payment per six months is one-half of the annual coupon payment. There are four months until the next coupon payment, so one month has passed since the last coupon payment. The accrued interest for the bond is:
Accrued interest = $72/2 × 2/6 = $12 And we calculate the clean price as:
Clean price = Dirty price – Accrued interest = $1,140 – 12 = $1,128
17. Accrued interest is the coupon payment for the period times the fraction of the period that has passed since the last coupon payment. Since we have a semiannual coupon bond, the coupon payment per six months is one-half of the annual coupon payment. There are three months until the next coupon
payment, so three months have passed since the last coupon payment. The accrued interest for the bond is:
Accrued interest = €65/2 × 3/6 = €16.25 And we calculate the dirty price as:
Dirty price = Clean price + Accrued interest = €865 + 16.25 = €881.25
18. To find the number of years to maturity for the bond, we need to find the price of the bond. Since we already have the coupon rate, we can use the bond price equation, and solve for the number of years to maturity. We are given the current yield of the bond, so we can calculate the price as:
Current yield = .0906 = $110/P0 P0 = $110/.0906 = $1,214.13
Now that we have the price of the bond, the bond price equation is:
P = $1,214.13 = $110[(1 – (1/1.085)t ) / .085 ] + $1,000/1.085t We can solve this equation for t as follows:
$1,214.13 (1.085)t = $1,294.12 (1.085)t – 1,294.12 + 1,000 294.12 = 79.99(1.085)t
3.6769 = 1.085t
t = log 3.6769 / log 1.085 = 15.96 ≈ 16 years
The bond has 16 years to maturity.
19. The bond has 10 years to maturity, so the bond price equation is:
P = $769.355 = $36.875(PVIFAR%,20) + $1,000(PVIFR%,20)
Using a spreadsheet, financial calculator, or trial and error we find:
R = 5.64%
This is the semiannual interest rate, so the YTM is:
YTM = 2 × 5.64% = 11.28%
The current yield is the annual coupon payment divided by the bond price, so:
Current yield = $73.75 / $769.355 = 9.59%
The “EST Spread” column shows the difference between the YTM of the bond quoted and the YTM of the U.S. Treasury bond with a similar maturity. The column lists the spread in basis points. One basis point is one-hundredth of one percent, so 100 basis points equals one percent. The spread for this bond is 468 basis points, or 4.68%. This makes the equivalent Treasury yield:
Equivalent Treasury yield = 11.28% – 4.68% = 6.60%
20. We found the maturity of a bond in Problem 18. However, in this case, the maturity is
indeterminate. A bond selling at par can have any length of maturity. In other words, when we solve the bond pricing equation as we did in Problem 18, the number of periods can be any positive number.
Challenge
21. To find the capital gains yield and the current yield, we need to find the price of the bond. The current price of Bond P and the price of Bond P in one year is:
P: P0 = $100(PVIFA8%,5) + $1,000(PVIF8%,5) = $1,079.85 P1 = $100(PVIFA8%,4) + $1,000(PVIF8%,4) = $1,066.24 Current yield = $100 / $1,079.85 = 9.26%
The capital gains yield is:
Capital gains yield = (New price – Original price) / Original price Capital gains yield = ($1,066.24 – 1,079.85) / $1,079.85 = –1.26%
The current price of Bond D and the price of Bond D in one year is:
D: P0 = $60(PVIFA8%,5) + $1,000(PVIF8%,5) = $920.15 P1 = $60(PVIFA8%,4) + $1,000(PVIF8%,4) = $933.76 Current yield = $60 / $920.15 = 6.52%
Capital gains yield = ($933.76 – 920.15) / $920.15 = +1.48%
All else held constant, premium bonds pay high current income while having price depreciation as maturity nears; discount bonds do not pay high current income but have price appreciation as maturity nears. For either bond, the total return is still 8%, but this return is distributed differently between current income and capital gains.
22. a. The rate of return you expect to earn if you purchase a bond and hold it until maturity is the YTM. The bond price equation for this bond is:
P0 = €1,150 = €80(PVIFAR%,10) + €1,000(PVIF R%,10)
Using a spreadsheet, financial calculator, or trial and error we find:
R = YTM = 5.97%
b. To find our HPY, we need to find the price of the bond in two years. The price of the bond in
b. To find our HPY, we need to find the price of the bond in two years. The price of the bond in