978-0133546408 Chapter 6 Solution Manual Part 2

P6-8. Risk-free rate and risk premiums

LG 1; Basic

a. Risk-free rate: RF  r*  IP

Security r*IP RF

c. Nominal rate: r  r*  IP  RP

Security r*IP RP r

P6-9. Risk premiums

LG 1; Intermediate

a. RFt r*  IPt

b. Risk premium:

c. ri  r*  IP  RP or r1  rF  risk premium

Security A has a higher risk-free rate of return than Security B due to expectations of higher near-term

P6-10. Bond interest payments before and after taxes

LG 2; Intermediate

c. Total before-tax interest $175,000

2 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition

P6-11. Bond prices and yields

LG 4; Basic

P6-12. Personal finance: Valuation fundamentals

LG 4; Basic

a. Cash flows: CF15$1,200

b.

3 51 2 4

01 2 3 4 5

(1 ) (1 ) (1 ) (1 ) (1 )

CF CF

CF CF CF

Vr r r r r

= + + + +

+ + + + +

01 2 3 4 5

$1,200 $1,200 $1,200 $1,200 $6,200

(1 0.06) (1 0.06) (1 0.06) (1 0.06) (1 0.06)

V= + + + +

+ + + + +

0$8,791V=

Using Calculator:

N  5, I  6, PMT  $1,200, FV  $5,000

P6-13. Valuation of assets

LG 4; Basic

Present Value of

Asset End of Year Amount Cash Flows

C 1 0 N  5, I  16 $16,663.96

D 1–5 $ 1,500 N  6, I  12, $9,713.53

E 1 $ 2,000 Use Cash Flow $14,115.27

Chapter 6: Interest Rates and Bond Valuation 3

Worksheet

P6-14. Personal finance: Asset valuation and risk

LG 4; Intermediate

a.

N PMT

@ 10%

Low Risk

@ 15%

Average Risk

@ 22%

High Risk

b. The maximum price Laura should pay is $13,030.92. Unable to assess the risk, Laura would use the

c. By increasing the risk of receiving cash flow from an asset, the required rate of return increases,

P6-15. Basic bond valuation

LG 5; Intermediate

a. I  10%, N  16, PMT  $120, FV  $1,000

b. Because Complex Systems’ bonds were issued, there may have been a shift in the supply-demand

c. I  12%, N  16, PMT  $120, FV  $1,000

When the required return is equal to the coupon rate, the bond value is equal to the par value. In

P6-16. Bond valuation—annual interest

LG 5; Basic

Bond Calculator Inputs Calculator Solution

$1,000

4 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition

P6-17. Bond value and changing required returns

LG 5; Intermediate

a.

Bond Calculator Inputs Calculator Solution

b.

c. When the required return is less than the coupon rate, the market value is greater than the par value,

d. The required return on the bond is likely to differ from the coupon interest rate because either

P6-18. Bond value and time—constant required returns

LG 5; Intermediate

a.

Bond Calculator Inputs Calculator Solution

Chapter 6: Interest Rates and Bond Valuation 5

b.

c. From the graph we can conclude that all else remaining the same, when the required return differs

P6-19. Personal finance: Bond value and time—changing required returns

LG 5; Challenge

a.

Bond Calculator Inputs Calculator Solution

b.

Bond Table Values Calculator Solution

c.

Value

Required Return Bond A Bond B

d. If Lynn wants to minimize interest rate risk in the future, she would choose Bond A with the shorter

P6-20. Yield to maturity

LG 6; Basic

Bond A is selling at a discount to par.

6 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition

P6-21. Yield to maturity

LG 6; Intermediate

a. Using a financial calculator, the YTM is 12.685%. The correctness of this number is proven by putting

the YTM in the bond valuation model. This proof is as follows:

b. The market value of the bond approaches its par value as the time to maturity declines. The yield to

P6-22. LG 6: Yield to maturity

LG 6; Intermediate

a.

Calculator

Bond Approximate YTM Solution

A

$90 [($1,000 $820) 8]

+ – ¸

C

$60 [($500 $560) 12]

[($500 $560) 2]

+ – ¸

+ ¸

 $10.38% 10.22%

D

$150 [($1,000 $1,120) 10]

[($1,000 $1,120 2]

+ – ¸

+ ¸

 13.02% 12.81%

E

$50 [($1,000 $900) 3]

[($1,000 $900) 2]

+ – ¸

+ ¸

 8.77% 8.95%

b. The market value of the bond approaches its par value as the time to maturity declines. The

yield-to-maturity approaches the coupon interest rate as the time to maturity declines. Case B

P6-23. Personal finance: Bond valuation and yield to maturity

LG 2, 5, 6; Challenge

a. N  5, I  12%, PMT  0.06  $1,000  $60; FV  $1,000

Chapter 6: Interest Rates and Bond Valuation 7

b. Number of Bond A bonds  $20,000  $783.71  25.520

c. Interest income of A  25.520 bonds$60  $1,531.20

d. At the end of the 5 years both bonds mature and will sell for par of $1,000.

e. The difference is due to the differences in interest payments received each year. The principal

payments at maturity will be the same for both bonds. Using the calculator, the yield to maturity of

P6-24. Bond valuation—semiannual interest

LG 6; Intermediate

P6-25. Bond valuation—semiannual interest

LG 6; Intermediate

Bond Computer Inputs Calculator Solution

P6-26. Bond valuation—quarterly interest

LG 6; Challenge

P6-27. Ethics problem

LG 1; Intermediate

Student answers will vary. Some students may argue that such a policy decreases the reliability of the

 Case

8 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition

Case studies are available on www.myfinancelab.com.

Evaluating Annie Hegg’s Proposed Investment in Atilier Industries Bonds

This case demonstrates how a risky investment can affect a firm’s value. First, students must calculate

the current value of Atilier’s bonds, rework the calculations assuming that the firm makes the risky investment, and

then draw some conclusions about the value of the firm in this situation. In addition to gaining experience in

b. Current value of bond under different required returns – annual interest

1. N  25, I  6%, PMT  $80, FV  $1,000

2. N  25, I  8%, PMT  $80, FV  $1,000

3. N  25, I  10%, PMT  $80, FV  $1,000

c. Current value of bond under different required returns – semiannual interest

1. N  50, I  3%, PMT  $40, FV  $1,000

2. N  50, I  4%, PMT  $40, FV  $1,000

3. N  50, I  5%, PMT  $40, FV  $1,000

Under all three required returns for both annual and semiannual interest payments the bonds are consistent in

their direction of pricing. When the required return is above (below) the coupon the bond sells at a discount

d. If expected inflation increases by 1%, the required return will increase from 8% to 9%, and the bond price

would drop to $901.77. This amount is the maximum Annie should pay for the bond.

e. The value of the bond would decline to $924.81 due to the higher required return and the inverse relationship

between bond yields and bond values.

Chapter 6: Interest Rates and Bond Valuation 9

f. The bond would increase in value and a gain of $110.61 would be earned by Annie.

g. The bond would increase in value and a gain of $91.08 would be earned by Annie.

Bond value at 7% and 15 years to maturity.

h. Antilier Industries provides a yield of 8% ($80) and is priced at $983.80 (0.98380  1,000). Hence,

i. Annie should probably not invest in the Atilier bond. There are several reasons for this conclusion.

 Spreadsheet Exercise

The answer to Chapter 6’s CSM Corporation spreadsheet problem is located on the Instructor’s Resource Center at

www.pearsonhighered.com/irc under the Instructor’s Manual.

 Group Exercise

Group exercises are available on www.myfinancelab.com.

This chapter is concerned with credit ratings. Each group is asked to use current information from their shadow

firm to flesh out the details for their fictitious firm. The first lesson students will learn is the lack of transparency in

The steps for the assignment are very straightforward. Each group is asked to retrieve the interest rate of a recent

The final step for the group is to address a potential capital investment. The interest rate will be derived from the