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Case 49 Beatrice Peabody Bond and Stock Evaluation

CASE INFORMATION Purpose This case is designed to review bond and stock valuation concepts. It is designed to illustrate the mechanics of valuation and to familiarize students with standard reporting formats of basic financial data. The case illustrates the impact of inputs into the valuation process. Time Required Without using the model, 6-8 hours of student preparation should be adequate for most students. An additional hour or so is needed to write up the case if required. Use of the spreadsheet model can reduce preparation time, especially if the completed model or the easy macro version is given to the students. Complexity B--Intermediate complexity. Much of the initial valuation is relatively straight forward, but it requires a fair amount of number crunching for students not using the spreadsheet model. Some of the questions involving risk adjustments are more difficult, and this raises the overall complexity of the case. Ways To Use the Case This case can be used in two different ways. With the introductory and not-very-well prepared second course students, students can be asked to read the case and then to become generally familiar with it. The case can then be used in class in lieu of a lecture to ensure that students understand how to obtain pertinent information from standard financial sources and to understand the issues involved in valuation. When the case is used in this manner, assign the directed version. The questions in the directed version lead students through the topics that should be addressed, and they provide structure to the class. The case itself sets the context in which all calculations and decisions are made, and this often works better than a pure lecture because the case makes the material seem more relevant. This usage is particularly effective with evening students and/or executives and managers. With more advanced students, the case can be assigned to teams. One team presents their findings and conclusions to the class, and a second team acts as the CEO to respond to the initial presentation, correct errors, make clarifications, and add to the understanding of the material. This allows students to improve their listening and response skills. The other teams are asked to prepare written reports with limited page requirements plus exhibits. Students can be asked to play the role of internal or external consultants, reporting to management or shareholders. When the case is assigned in this manner, the non-directed version is recommended. With the directed version, the presentation and reports are too mechanical -students just answer the specific questions. With the non-directed version, students have more scope to consider different things, and to use different numbers in arriving at their answers. This makes things more interesting, and discussions among the students are more likely to arise. In either type of usage, students should read the relevant chapter(s) in a standard finance
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textbook. (Some texts work better than others for reference purposes, but all texts cover the material in this and other cases.) Students should be informed that in this case, as in the business world, they may not be provided all the data and other information they would like. If an issue is addressed in the text or chapter that seems relevant to the case, but no data is provided in the case, the students should discuss how they, as consultants, would go about getting the missing data and then using it. They can be encouraged to make up realistic data and then analyze it within the context of the case. This sometimes forces students to think about different but relevant issues and it opens things up in terms of giving them scope for digging into the subject. Instructor Preparation Regardless of which version is used, the instructor should read through the case and then read through the questions and answers provided in this solution. The questions are from the directed case, and they touch on most of the points that students are likely to bring up when they go through the case. Other points could be made, but the questions and answers will give a good indication of how to deal with the case. MODEL INFORMATION Description The spreadsheet model for this case is saved under the filename Case49I.WK1 (Lotus version) and Case49I.XLS (Excel version). The model calculates values, yields and EAR for semiannual payment bonds identified in the case. It also calculates preferred and common stock price and return. The INPUT DATA and KEY OUTPUT sections of the model are shown below. Model Use For consistency, we developed a spreadsheet model for this case. However, we emphasize financial calculator solutions for learning the models and the spreadsheet application for sensitivity analysis to determine how changes in the variables affect the results. There is some danger that beginning students will not really understand the basic logic underlying the model if they are not required to do some calculations by hand.

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INPUT/OUTPUT INPUT DATA:

KEY OUTPUT:

Bond and Note Analysis:

Bond and Note Analysis:

8-Year Note 2003): Annual coupon rate Par value Required return Price 6.70% $1,000 8.50% $910.20

8-Year Note: Semiannual coupons: Value YTM EAR 26-Year Bond: Semiannual coupons: Value YTM EAR 28-Year Bond: Semiannual coupons: Value YTM EAR $872.92 8.50% 8.68% $1,024.96 8.39% 8.57% $897.04 8.26% 8.43%

26-Year Bond (2021): Coupon rate Par value Required return Price 9.25% $1,000 9.00% $1,090.50

28-Year Bond (2023): Coupon rate Par value Required return Price 7.75% $1,000 9.00% $920.34

Preferred Stock Analysis: (Series K) Dividend yield Par value Price 3.380% $100.00 $43.50

Preferred Stock Analysis: (Series A) $ Div. Nom return EAR return $3.38 7.77% 8.00%

Common Stock Analysis:

Common Stock Analysis:

Constant growth model:


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Price

$20.98

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Next dividend (D1) Normal growth rate Required rate Price

$0.60 5.50% 8.36% $27.00

Return

7.72%

Non-constant growth model: Non-constant growth rates: 1996 1997 1998 1999 Normal growth rate Required rate Next dividend (D1) 4.00% 4.00% 4.00% 4.00% 8.00% 9.50% $0.60 Value Yield : Yr. 1992 1993 1994 1995 1996 $34.58 Div. Yld 1.74% 1.67% 1.62% 1.56% 1.50% CG Yld Tot Yld 7.76% 9.50% 7.83% 9.50% 7.88% 9.50% 7.94% 8.00% 9.50% 9.50%

1. According to ValueLine estimates in figure 1, James River's expected annual dividend growth rate from the 91-93 to 97-99 period is 5.50%, and the next dividend (1995) is expected to be $0.60. Assume that the required return for James River was 8.36% on January 1, 1995 and that the 5.50% growth rate was expected to continue indefinitely.
a. Based on the constant growth rate, or Gordon Model, what was James River's price at the beginning of 1995? P0 = D1 k-g = $0.60 .0836 - .0550 = $20.98

b. What conditions must hold to use the constant growth model? Do many "real world" stocks satisfy the constant growth assumptions? The constant growth model requires that per share dividends are expected to grow at some constant rate forever. This implies that the company's earnings (and presumably its sales and assets) are also expected to grow at that same constant rate, and that the payout remains constant. No real world stocks meet the constant growth assumptions on an ex post basis, but rather ex ante; the assumption is not unreasonable for large, mature companies. The constant growth assumption does not require that one literally expect the growth rate to be identical each year. All that is required is that the best current estimate of growth for any future year is the expected growth rate from the previous year. Often, companies increase dividends only after management is confident that the company will be able to continue paying, at a minimum, the new level of dividend into the future. Note: James Rivers stock dividends grew rapidly from 1978 through 1989, although the dividend
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was held constant in 1982, 1985, and 1987. In 1990 the company started experiencing earnings difficulties, and the company held the dividend at $0.60 (except for 1991 when the dividend decreased). The ValueLine analysts expect the company to work through their current difficulties and increase dividends by 1997-99 to $0.80. In general, future dividends are very difficult to estimate and, hence, there is much uncertainty in the entire stock valuation process. Because the constant growth model is a reasonable long run approximation, it is often applied even when the firm does not strictly meet the assumptions. However, if dividend growth is expected to vary in a systematic way, such as when dividends have been omitted or early in a firm's life, then the non-constant growth model should be used. 2. The Wall Street Journal (WSJ) lists the current price of James River common stock at $27.00. a. Based on this information, the ValueLine 1995 expected dividend, and the annual rate of dividend change for the growth estimate, what is the company's return on common stock using the constant growth model? What is the expected dividend yield and expected capital gains yield? Explain the difference in the required return estimates from the ValueLine (see question 1a) to the WSJ price data. Expected return = D1 / P0 + g = $0.60/$27 + 5.50% = 2.22% + 5.50% = 7.72%. Expected dividend yield = D1 / P0 = 2.22%. Note: this corresponds to the dividend yield reported in the WSJ. Expected capital gain yield is the expected growth at 5.50%. Investors expectations concerning either the future cash flows or the risk of the company changed between the time of the ValueLine estimates and the WSJ transaction information. The increased price of the stock indicates expectations of higher value. We find that the expected return on the stock decreased from 8.36% to 7.72%. Since the constant growth model assumes a constant growth rate in expected cash flows, this indicates that investors expect the company to be less risky. b. What is the relationship between dividend yield and capital gains yield over time under constant growth assumptions? Under constant growth, both dividends and price grow at the same constant rate. Therefore, the dividend yield and the capital gains yield remain constant over time. 3. A successful joint venture is expected to result in the 4.0% growth rate until 2000 but would increase the company's normal growth rate to a constant 8.00% after that time. The joint venture also is expected to increase investors' required return to 9.50%. b. Based on this information, what is the value of the company's stock? The value of the stock is the present value of all expected future dividends. Dividends are expected to be $0.60 next year and grow at 4.0% for the following four years before following the normal growth model. Thus to value the stock, find the expected dividends for each year during the non-constant growth period and the price when the normal growth period starts. Then, sum the discounted value of each cash flow back to the present. Year Dividend PV Dividend 1996 0.60 = 0.600 .60/(1.095) = 0.55 1997 0.60(1.04) = 0.624 = 0.52 .624/(1.095)2 1998 0.633(1.04) = 0.649 = 0.49 .649/(1.095)3 1999 0.649(1.04) = 0.675 4 = 0.47 .675/(1.095) 2000 0.675(1.04) = 0.702 = 0.44 .702/(1.095)5
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In year 2000 you also receive the price at the constant growth of 8%. P2000 = D200 = $0.702(1.08) 1 k-g .0950 - .0800

0.758 .015

= $50.544

1995 1996 1997 1998 1999 2000 2001 /--------------/-----------/-----------/------------/------------/-----------/ .60 .624 .649 .675 $ 0.702 =>Normal $50.54 growth The present value of the price at the year 2000 = 50.554/(1.095)5 = $32.11. The present value of the expected cash flow stream is $0.55 + .52 + .49 + .47 + .44 + 32.11 = $34.58 b. What is the value of the stock at the end of the first year assuming that the stock is in equilibrium? At the end of the year the stock price (value) is one year further on the time line. After the initial dividend of $0.624 only three more dividends will be paid at the lower 4.0% growth rate, and the constant growth rate starts in 2000. The expected stock price is found as follows: 1996 1997 1998 /--------------/-----------/------------/------------/-----------/--------.624 .649 .675 $ 0.702 Normal $50.544 growth $51.246 1999 2000 2001

Value = .624/(1.095)+ .649/(1.095)2 .675/(1.095)3 + (.702 + 50.544)/(1.095)4 = .57 + .54 + .51 + $35.65 = $37.27. A listing of stock prices each year from the spreadsheet is below. (Note some differences due to rounding) End of Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 t 0 1 2 3 4 5 6 7 8 9 Div. 0.60 0.62 0.65 0.67 0.70 0.76 0.82 0.88 0.95 Stock Value $34.58 37.27 40.18 43.35 46.79 50.54 54.58 58.95 63.66 68.76

c. What is the dividend yield, capital gains yield, and total yield of the stock for the year? If you are using the spreadsheet model for this case, discuss the changes in dividend yields and capital gains yields over time. In each year t, the dividend yield is Dt/Pt-1, the capital gains yield is (Pt - Pt-1) / Pt, and the total yield is dividend yield plus capital gain yield. For 1996 the dividend yield = $0.60/$34.58 = 1.74% The capital gains yield = ($37.27 - $34.58)/$34.58 = 7.78%
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The total yield = 1.74% + 7.78% = 9.52% A listing of stock prices each year from the spreadsheet is listed. (Note some differences due to rounding).

End of Year
1996 1997 1998 1999 2000 2001 2002 2003 2004

Div. Yield
1.74% 1.67% 1.62% 1.56% 1.50% 1.50% 1.50% 1.50% 1.50%

CG Yield
7.76% 7.83% 7.88% 7.94% 8.00% 8.00% 8.00% 8.00% 8.00%

Total Yield
9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50%

The dividend yield decreases each year while the capital gains yield increases each year of the non-constant growth period. This is because the growth rate in the constant growth phase is higher than in the initial non-constant growth phase. The net affect is that the total yield remains at the required return of 9.50%. The mathematics of the discounting process forces the stock price to be such that the expected return equals the required return. Note that in 2000 and thereafter, the capital gains yield equals the constant growth rate of 9.50%. d. Suppose that the dividend was expected to remain constant at $0.60 for the next five years and then grow at a constant rate of 5.50%. If the required return is the original 8.36% from question 1, would the stock value be higher or lower than that in part a? If you are using the spreadsheet model for the case, calculate the dividend yield, capital gains yield, and total yield from 1996 through 2004. The value of the stock would be lower than the $20.98 price in question 1 if the initial dividends remained constant at $0.60 rather than growing at 5.50% each year. The lower value is the result of lower expected cash flows for the first five years.

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1995 1996 1997 1998 1999 2000 2001 /--------------/-----------/-----------/------------/------------/-----------/ .60 .60 .60 .60 $ 0.60 Normal $22.13 growth $22.73 Price = $17.18 The dividend yields, capital gains yields, and total yields for 1996 through 2004 are as follows: Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 Div. Yield 3.49% 3.33% 3.17% 3.01% 2.86% 2.86% 2.86% 2.86% 2.86% CG Yield 4.87% 5.03% 5.19% 5.35% 5.50% 5.50% 5.50% 5.50% 5.50% Total Yield 8.36% 8.36% 8.36% 8.36% 8.36% 8.36% 8.36% 8.36% 8.36%

4. One method of determining the company's growth rate is from the fundamentals of the retention ratio and return on retained earnings. How does the growth rate -- based on ValueLine's 1997-1999 estimated retention ratio (Hint: use 1 - % all dividends to net profit) and expected return on retained earnings of 10.5% -- affect the return on the stock as compared to the initial return found in question 2? g=b*r g = .51 ( 10.5%) = 5.36% Expected return = D1 / P0 + g = $0.60 / $27 + 5.36% = 2.22% + 5.36% = 7.58%. The growth rate is slightly smaller than the dividend growth forecast of 5.5%. Thus the expected return of 7.58% is also somewhat lower that the 7.73% return found in question 2. 5. Using the yields for the 10 year T-bond from the Wall Street Journal, an annual average risk premium of stock over risk free treasuries of 6.20%, and the beta from ValueLine, what is the required return on the stock based on the CAPM? How does this return compare to the return found in question 2? Based on the CAPM: Expected return = Rf + _ (Rm - Rf) Expected return = Rf + _ (risk premium) K = 6.40% + 1.2 ( 6.2%) = 13.84% The required return is far greater than the expected return found in question 2. This implies that the inputs into the models are not consistent. The estimated constant growth rate of 5.5% may be understated. Growth is expected to increase in the future. Alternatively, investors do not expect the historical beta of 1.2 to represent the future risk of the company. The analysis indicates that, given a constant growth rate, the stock does not provide the return required for a stock with risk 20% greater than the market. 6. Answer the following questions on preferred stock using the Wall Street Journal stock information. a. What is the nominal expected rate of return for James River series K preferred stock? (Hint:
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Preferred stock pays a quarterly dividend.) What is the effective annual rate? Nominal Rate: Preferred stock is a perpetuity and is valued as D/kp. The rate of return = D/P. The Wall street Journal lists the series K preferred stock annual dividend at $3.38 and the price at $43.50. Nominal return = $3.38/$43.50 = 7.77%. This is consistent with the WSJ dividend yield of 7.8%. Effective Rate: Quarterly dividend = $3.38 / 4 = $0.845 Quarterly return = $0.845/$43.50 = 1.94% Effective annual rate = (1.0194)4 -1 = 08.00% b. What is the value of the preferred stock if it has a sinking fund in which 20% of initial issue of stock was redeemed annually at par ($100) and the required nominal return is 9.76%? A sinking fund issue is no longer a perpetuity. The valuation changes to the present value of expected future cash flows. The number of years is based on the expected holding period. If 20% of the shares are redeemed annually, the probability of holding the stock each year is 20% and the expected holding period if the following Years = .2(1) + .2(2) + .2(3) + .2(4) + .2(5) = 3 years n = 3 years (4 quarters per year)= 12 The payment each quarter = $0.845. Future value at redemption = $100 Discount rate = 9.76/4 = 2.44% Price = $83.58 7. Answer the following questions concerning James River debt using the S&P Bond Guide Information. a. Why do the coupon rates of James River debt vary so widely? Companies generally sell bonds at par and set the coupon rate at the market rate of interest when the bonds are issued. Interest rates have declined over the period when the 2021 and 2023 bonds were issued; consequently coupons may have also dropped. Other possible explanations include the following. The lower coupon for the 2003 notes may result from an upward sloping yield curve. Investors may believe that rates will rise and therefore require a higher rate for the longer term bonds. Longer term bonds may include a larger term premium. The risk characteristics of the company may have change between issues, resulting in a larger required return and coupon at issue. b. Based on the required returns of 8.5% and 9% for similar short term and long term bonds respectively, what are the values of the semiannual coupon bonds and notes held in Ms. Peabody's portfolio? Are the bonds and notes selling at a discount or a premium. 8-year note: Semiannual coupon payments = 6.7%($1,000)/2 = $33.50 Number of semiannual payments = 8 (2) = 16 Future Value at maturity = $1,000 Required semiannual return = 8.50%/2 = 4.25% Compute price = $897.04 26-year bond: Semiannual coupon payments = 9.25%($1,000)/2 = $46.25 Number of semiannual payments = 26 (2) = 52
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Future Value at maturity = $1,000 Required semiannual return = 9.00%/2= 4.50% Compute price = $1,024.96 28-year bond: Semiannual coupon payments = 7.75%($1,000)/2 = $38.75 Number of semiannual payments = 28 (2) = 56 Future Value at maturity = $1,000 Required semiannual return = 9.00%/2 = 4.50% Compute price = $872.92 The note and 28 year bond have coupons below their respective required returns and are selling below their $1,000 par value. Therefore, they are selling at a discount. The 26 year bond has a coupon above the required return and is selling above the $1,000 par value. Therefore, it is selling at a premium. 8. Based on the bond analysts current expected prices of the company's debt, what is the nominal yield to maturity of each issue in the portfolio? What is the effective annual rate? Would you expect a semiannual payment bond to sell at a higher or lower price than an otherwise equivalent annual payment bond? Explain why. 8-year note: Semiannual coupon payments = 6.7%($1,000)/2 = $33.50 Number of semiannual payments = 8 (2) = 16 Future value at maturity = $1,000 Present value or Price = $910.20 Computed semiannual rate = 4.13% Nominal rate of return = 4.13 (2) = 8.26% Effective annual rate = (1.0413)2 - 1 = 8.43%

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26-year bond: Semiannual coupon payments = 9.25%($1,000)/2 = $46.25 Number of semiannual payments = 26 (2) = 52 Future Value at maturity = $1,000 Price = $1,090.50 Compute semiannual rate = 4.19% Nominal rate of return = 4.19%(2) = 8.38 Effective annual rate = (1.0419)2 - 1 = 8.56% 28-year bond: Semiannual coupon payments = 7.75%($1,000)/2 = $38.75 Number of semiannual payments = 28 (2) = 56 Future Value at maturity = $1,000 Price = $920.34 Compute semiannual rate = 4.25% Nominal rate of return = 4.25 (2) = 8.50% Effective annual rate = (1.0425)2 - 1 = 8.68% A semiannual coupon payment bond should sell at a higher price than an otherwise equivalent annual coupon payment bond. The fact that some of the coupons are received earlier and can be invested longer make semiannual coupon bonds more valuable. However, if you compute the price of an annual bond with a given coupon and a semiannual bond with a coupon half that of the annual bond, the price of the annual coupon bond will be greater. This is because you are discounting with a smaller nominal annual rate rather than the effective annual rate. If both were discounted by the same effective annual rate, the semiannual bonds would provide a higher value. 9. Assume that James River Corporation's anticipated new 28 year 12% bond is not callable and sells for $1,371.73 a. What is the nominal and effective annual YTM on this bond? Semiannual coupon payments = 12%($1,000)/2 = $60.00 Number of semiannual payments = 28 (2) = 56 Future Value at maturity = $1,000 Price = $1,371.73 Compute semiannual rate = 4.25% Nominal rate of return = 4.25 (2) = 8.50% Effective annual rate = (1.0425)2 - 1 = 8.68% b. What is the current yield on this and the original 28 year bond selling for $920.34? Current yield = i (Par)/ P0 Discount bond current yield = $77.50/$920.34 = 8.42% Premium bond current yield = $120/$1,371.73 = 8.75% The current yield for the higher coupon bond is greater.

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c. What is each bonds expected price after one year assuming they both have a YTM of 8.50%? What is the capital gains yields for the year for each bond assuming no change in interest rates? Price after one year: Discount bond: Semiannual coupon payments = 7.75%($1,000)/2 = $38.75 Number of semiannual payments = 27 (2) = 54 Future Value at maturity = $1,000 Required semiannual return = 8.50%/2 = 4.25% Compute price = $921.09 Premium bond: Semiannual coupon payments = 12%($1,000)/2 = $60.00 Number of semiannual payments = 27 (2) = 54 Future Value at maturity = $1,000 Required semiannual return = 8.50%/2 = 4.25% Compute price = $1,368.26 Capital Gains Yield Discount bond capital gains yield = ($921.09 - $920.34) / $920.34 = 0.08% Premium bond CG yield = ($1,368.26 - $1,371.73)/ $1,371.73 = - 0.25% d. What is the expected total (percentage) return on each bond during the next year? Total return = current yield + capital gains yield Discount bond total yield = 8.42% + 0.08% = 8.50% Premium bond total yield = 8.75% - 0.25% = 8.50% The discount bond has a lower current yield but has a capital gain. The premium bond has a higher current yield but has a capital loss. The total return on each bond is the same and equal the required return. e. What would happen to the price, current yield, and total return of each bond over time assuming constant future interest rates. The price of the premium bond would decrease each year until it reached par at maturity. The current yield would increase as the price declines. Total yield would remain the same. The price of the discount bond would increase each year until it reached par at maturity. The current yield would decrease as the price increases. Total yield would remain the same. f. If you were a tax-paying investor, which bond would you prefer? Why? What impact would this preference have on the prices ( hence YTM) of the two bonds? An investor paying taxes would prefer the discount bond. The taxes paid each year on the lower coupon bond would be lower and the larger capital gains would be deferred. Thus, the investor would incur a larger present value total tax liability over the life of the bond if he or she bought the premium bond. Since after-tax return is the relevant return, investors would bid up the price of the discount bond and bid down the price of the premium bond. The lower price of the premium bond would result in a higher return. In equilibrium, the premium bond would offer a higher before-tax YTM than the discount bond all other things equal. But on an after tax basis, the yields would be identical to that of the marginal investor. 10. Assuming the proposed 28 year bond is callable and sells for $1,225, what is the yield to first call? Do you think it is likely that the bond will be called? Explain how the probability of call affects the required yield on a bond. The yield to first call requires valuing the bond as if the bondholder will only hold the bond for 5 years and will receive a call premium of one years interest ($120) in addition to par at the time the
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bond is called. Semiannual coupon payments = 12%($1,000)/2 = $60 Future value (at call) = $1,000 + $120 = $1,120 Number of payments = 5 years (2) = 10 Present value or price = $1,225 Computed semiannual yield = 4.19% Nominal yield = 4.19% (2) = 8.38% Given the high coupon level, it is likely that the company will call the bond and issue new bonds as a lower coupon rate. Because there is a probability that the bond will be called, investors will require a slightly higher rate of return to compensate for the risk of not being able to hold the bond to maturity. 11. Consider the risk of the bonds. a. Explain the difference between interest rate price risk and coupon reinvestment rate risk. Price risk is the risk incurred because a fixed income security (such as a bond) will lose some of its market value if interest rates rise. For example, coupon rates are set at issue. As investors' required rates increase, the existing coupon will look less attractive and the bond price will drop. As investors' required rates decrease, the existing coupon will look more attractive and the bond price will increase. Coupon reinvestment rate risk is the risk incurred because the funds received from fixed income securities can only be invested at the current market rates rather than the YTM. b. Which of the two long term bonds in Ms. Peabody's portfolio have the greatest price risk? Why? If you are using the case spreadsheet model, illustrate your answer by calculating the change in value of each bond assuming the interest rates rose from the initial 9% to 12% and dropped from 9% to 6%. The longer term and lower coupon bonds have the greatest price risk. The longer the maturity of the bond the more a bonds price will be affected by a change in rates because of the compounding affect. The lower the coupon rate the greater the sensitivity to interest rates changes, as less of the return is generated by the current rate and more through price changes. Interest rate risk is a function of the bonds duration rather than its maturity. Duration is the average time the investors holds the asset. It is composed of the weighted average of all coupon and maturity payments, where the weights are a function of the length of time to receive each payments. The longer the bonds term to maturity and the lower the coupon rate t, the longer the duration. Required nominal rate 9% 12% 6% Price (26 year higher coupon bond) $1,024.96 $789.91 $1,425.20 % change --22.93% 39.05% Price (28 year lower coupon bond) $872.92 $659.39 $1,235.95 % change --24.46% +41.59%

The change in price for the higher coupon bond is less than that for the lower coupon bonds for both the increase and decrease in required return. c. Assume that you have money to invest in a bond but need the proceeds of the investment in 10 years. Which type of bonds could you purchase to eliminate interest rate risk? A zero coupon bond with a 10 year maturity would eliminate interest rate risk. You would receive the par value at the same time as you needed your funds and, therefore, you would not be affected by price risk. You would not receive coupon payments and, therefore, you would not be affected by needing to reinvest at the prevailing rate. A bond with a duration equal to the 10 year investment
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horizon would also eliminate interest rate risk. With matching duration an increase in price due to a drop in interest rates would be exactly offset by the decrease in interest income from reinvested coupons at the lower rates. An increase in interest rates would cause matching decrease in price and increase in investment income from coupons. 12. Assume Ms. Peabody sold some of her James River bonds and bought a 5 year 9% coupon bond selling at par. a. Immediately after the bond was purchased, market rates fell to 6%. Given she can only invest her coupons at 6% what is the actual realized return on her investment? (Hint: Find the terminal (future) value of her coupons and the par value at maturity. Then find the rate of return that equates the price with the terminal value.) How does the actual realized return compare with the expected rate of return? Find the terminal value of coupons Payment = 9% ( $1,000) / 2 = $45.00 Number of payments = 5 ( 2) = 10 Compound rate = 6%/2 = 3% Compute future value coupons = $515.87 Future value of coupons plus par = $1,515.87 Compute the compound rate that equates present value of $1,000 with future value of $1,515.87 over 10 periods with no annuity payments. Computed semiannual rate 4.25% Effective actual realized annual rate = 8.68% The actual realized rate is lower than the initial YTM because the coupons would be invested at a lower rate. b. What would happen if the interest rates increased rather than decreased? The actual realized rate would be higher because the coupons could be invested at a higher rate c. How would the results differ if she would have bought a longer term bond? If the bond had a longer term, the differences would be greater because more coupons would be invested at the new market rates for a longer period of time. 13. Many bond market participants are speculators as opposed to long-term investors. If you thought interest rates were going to fall from current levels, what type of bonds would you advise Ms. Peabody to purchase in order to maximize short-term capital gains? She should purchase longer-term, lower coupon bonds as they are most sensitive to interest rate changes and will have the greatest interest rate risk. If interest rates fell these bonds would have greater price increases.

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