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.

ANSWER: -

This statement is false.

The possibility of interest rates change is higher in long run contrast within the short term.

Subsequently, bonds with longer development period may need to sell at the markdown cost, or

interest fee may go down/up. While in short run risk of changes (build/diminish) in interest cost

is low because the likelihood of massive change in interest rate is low.

Since short-term bond matures inside of 12 months, it is advantageous for a financial specialist to

hold till development though long haul bond has maturity period 10 to 15 years and might need

to offer in the middle of and speculator may need to sell their bonds at markdown cost.

Henceforth long haul bonds costs are more sensitive to interest rate changes than are short-term

bonds cost.
(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?

ANSWER: -

On the off chance that interest rates in the economy ascend after a bond have been issued in the

business sector, then bonds cost will be tumbled down in light of the fact that bond will pay less

coupon interest than recently issued bonds consequently bond would be offer in cost less than

par.

On the off chance that interest costs in the economy build, respect maturity additionally

increment since respect development and business sector financing cost is the same. Respect

development is entirely of current yield and positive/negative capital additions yield. At the point

when business sector funding cost falls the value of bonds goes down that makes positive capital

gain and henceforth expands yield to maturity.

Yes, the length of time to maturity affects the extent to which a change in interest affects the

bonds price. Bonds with the longer term to maturity can have higher increase/decrease into

bonds prices given changes in interest rate than the bonds with a shorter term to maturity.

(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.

ANSWER: -
In the event that interest rate decrease in the business sector, the estimation of callable bonds

won't ascend as much as general bond (bonds with no call alternative). The reason is that issue of

bonds has the option to reclaims the bond whenever and when interest rate decrease in the

business sector this is the ideal time for them to recover the bonds with high-interest rate and

issue new bonds with the low winning business sector interest rate.

(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.

ANSWER: -

(1) The corporation makes yearly installments to the trustee, who puts the returns in securities

(every now and again government bonds) and utilizes the collected aggregate to resign the bond

issue at development.

(2) The trustee utilizes the yearly installments to retire a part of the issue every year, either

calling a given rate of the issue by a lottery and paying a predefined cost for each bond or

purchasing bond on the open business sector, whichever is less expensive.

Firms Advantages: 1. subsequent to the cash is invested by the company every one of the

speculations stays on the company's financial record, and company' balance sheet strong. 2. A

significant part of the administrative work and costs of retiring the bond consistently is saved.

Firms Disadvantages: 1. the reinvestment risk is with the bond holder and if the loan rate

decreases amid the lifetime of bonds then bond holder will need to contribute the returns at lower

interest rate. 2. The company's balance sheet stays free of leverage and it is simpler to get loans.
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?

ANSWER: -

P = F*r*[1 -(1+i)^-n]/i + C*(1+i)^-n, with

F = par value

C = maturity value

r = coupon rate per coupon payment period

i = effective interest rate per coupon payment period

n = number of coupon payments remaining

We have F = 1000.

C assumes to be the same as par value = 1000 since it's not given.

r = .08

i = .09

n = 12

Plug in

P = 1000*.08 * (1 - 1.09^-12)/.09 + 1000*1.09^-12 = $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?

ANSWER: -

100+1000-850/12/1000+850/2 = 112.5/925 = .1216 or 12.16%

Other way Plug into financial calculator

Number of periods (N)= 12

Present value (PV)= 850

Future value (FV)= -1000

Payment (PMT)= -100

End of period - ordinary annuity.

Solve for interest rate and get: press CPT then I/Y and you can get the yield to maturity 12.475%

(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?

ANSWER: -

YTM-Liquidity-Risk free = default risk premium...

YTM = 9%

Liquidity = 0.5%

Risk free = 6%

9%-0.5%-6% = 2.5%
(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?

ANSWER: -

K= K* + IP + DRP + LP + MRP

KT-2 = 6.3% = 3% +3% + MRP; DRP=LP=0

MRP = 6.3%-6%

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?

ANSWER: -

In finance calculator FV =1,000, PMT= 50, N= 16, R= 4.25%, PV=?

Press CPT then PV

Present Value = $1,085.80

Other way we can calculate 50*11.44+1000*.5138 = 1086

(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?
ANSWER: -

F= 1,000

PMT = 40

N = 20

PV = 1,100

Yield to Maturity= 3.31% * 2 = 6.62%

Also

F= 1,050

PMT = 40

N = 10

PV = 1,100

Yield to Call = 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.

ANSWER: -

A. (1) PV = 829

N=4

FV = 1000
PMT =90

CPT I/Y

I/Y = 14.99%

YTM = 13.978% (829)

YTM = 6.498% (1104)

B. YES, IF YOU THOUGHT THE APPROPRIATE RATE WAS 12%, YOUR PV WOULD

ACTUALLY BE HIGHER MEANING YOU WOULD BE WILLING TO PAY MORE THAN

$829.

(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?

ANSWER: -

YTM = [C + (F-P)/n] / [(F+P)/2

0.105883 = [C + (1,000 - 1,020)/7] / [(1,000+1,020)/2]

Annual Coupon Amount = $110

Current Yield = Interest amount / Current bond 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?

ANSWER: -

Nominal interest rate is given as

r = r* + IP + MRP

r* is the risk free rate

DRP = LP = 0.

IP = [(3%) 1 + (4%) 1 + (3.5%) 5]/7 = 3.5%.

MRP = 0.0005 %( 7 − 1) = 0.003%.

r12 = 3% + 3.15% + 0.003% = 6.153%.

(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?

ANSWER: -

A.

TTM = 10 years Par = $1,000 Coupon = 10% ($50 payments) r = 6% (after two years)

Using Financial Functions on

n = (10 x 2) - (2 x 2) = 16 i = 6% x .5 = 3

PMT = $100 x .5 = 50

FV = 1000
PV = solve

PV = -$1,251.2220

Bond Price = $1,251.22

B.

Suppose that 2 years after the initial offering, the going interest rate had risen to 12%. At what

price would the bonds sell?

TTM = 10 years Par = $1,000 Coupon = 10% ($50 payments) r = 12% (after two years)

Using Financial Functions on:

n = (10 x 2) - (2 x 2) = 16 i = 12% x .5 = 6

PMT = $100 x .5 = 50

FV = 1000

PV = solve

PV = -$898.9410

Bond Price = $1,251.22

Bond Price = $898.94

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?

As time progresses, the price/value of the bond will slowly decrease. This table illustrates that:

Using Financial Functions: (Assume i, PMT, and FV remain constant for following figures) n

Price

20 $1,297.55
16 $1,251.22

12 $1,199.08

8 $1,140.39

4 $1,074.34

2 $1,038.27

Therefore, the price decreases over time.