Finance Chapter 12 This Assumption Crucial Because Implicit The Mathematical Equation That Solves For Promised

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CHAPTER 12

BOND FUNDAMENTALS AND VALUATION

Answers to Questions

1. The three factors affecting the price of a bond are coupon, yield, and term to maturity. The

relationship between price and coupon is a direct one—the higher the coupon, the higher

2. Interest income from municipal bonds is normally not taxable by the federal government or

3. Calling a bond allows the issuer to retire the bond prior to its maturity. Callable bonds have

a call premium, which is the amount above par value that the issuer must pay to the

4. The purpose of bond ratings is to assess the possibility of default by the issuer. The

5. The differences between the Japanese and U.S. bond markets are clear from Exhibit 12.2.

The Japanese bond market is dominated by government bonds, which accounted for 81.4

percent of their market in 2010. The corporate sector accounted for only 11.1 percent. In

6. The difference between a foreign bond and a Eurobond can be broken down as a

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or in part.

difference in issuer and the market in which they are issued. For example, a foreign bond

in Japan (for example, a Samurai) is denominated in the domestic currency (yen) and is

sold in the domestic market (Japan), but it is sold by non-Japanese issuers. On the other

hand, a Eurobond is denominated in the domestic currency (yen), but it is sold outside the

domestic country in a number of national markets. These bonds are typically underwritten

by international syndicates. The relative size of these two markets varies by country.

7. The discounted cash flow valuation equation is more useful for the bond investor, largely

because the bond investor has fewer uncertainties regarding future cash flows than does the

common stock investor. By investing in bonds with relatively no default risk (i.e.,

government securities) the investor can value a bond based primarily on expected cash

8. The most crucial assumption in both cases that the investor makes is that cash flows will be

9(a). RFR is the riskless rate of interest, I is the factor for expected inflation, and RP is the risk

premium for the individual firm.

9(b). The model considers the firm’s business conditions. The risk of not breaking even would

10(a). The term structure of interest rates refers to the relationship between yields and maturities

for fixed income securities with similar credit risk. Expectations regarding future interest

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of longer maturity bonds.

10(b). According to the expectations theory of yield curve determination, if borrowers prefer to

sell short maturity issues at the time lenders prefer to invest in longs, which happens

10(c). The “real” rate of interest is simply the difference between nominal interest rates and

10(d). Over the past several years, fairly wide spreads have existed between AAA-corporates

and Treasuries. Investor preference for Treasuries stems from several factors. Treasury

securities typically are extremely liquid and provide investors with more flexibility.

Secondly, Treasury securities typically do not have restrictive call features generally

11. The asset-backed securities (ABS) market involves securitizing other types of debt

besides residential mortgages. Most ABSs are backed by one specific type of asset

CHAPTER 12

Answers to Problems

1(a). Present Value = Future Value / (1 + discount rate)n

1(b). PV = $1,000 / (1.05)40 = 142.05

2.

2(a). For the 15% tax bracket

2(b). For the 25% tax bracket

2(c). For the 35% tax bracket

3.

Assuming all other relevant factors are equal, the corporate bond carrying an 8 percent

coupon and selling at par offers a better return than a 5.5 percent municipal bond (with

t– 1

i

ETY =

9.88%or .0988

.85

.084

.15 – 1

.084

ETY ===

11.20%or .1120

.75

.084

.25 – 1

.084

ETY ===

12.92%or .1292

.65

.084

.35 – 1

.084

ETY ===

07639.

72.

055.

28.1

055.

t– 1

i

ETY ==

−

==

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4(a). Present Value = Future Value / (1 + discount rate)n

4(b). PV = $1,000 / (1.04)24 = 390.12

4(c). PV = $1,000 / (1.05)24 = 310.07

5(a). PV = $1,000 / (1.06)40 = 97.22

5(b). PV = $1,000 / (1 + r)n inserting the known items,

5(c). PV = $1,000 / (1 + r)n inserting the known items,

6.

6(a). Using a financial calculator: PV= -1000, FV = 1100, PMT = 35, n= 8, as the bonds were

6(b). Using a financial calculator: FV = 1000, PMT = 35, n= 42, as the bonds mature in 21

7.

7(a). Using a financial calculator: PV= -1012.50, FV = 1000, PMT = 40, n= 24, as the bonds

7(b). Using a financial calculator: PV= -1012.50, FV = 1080, PMT = 40, n= 6, as the bond is

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8(a). Current yield = Annual dollar coupon interest / Price = 70/960 = 7.3%.

8(b). The annual yield to maturity (YTM), using a financial calculator, is found using these

8(c). Horizon yield (also called total return) accounts for coupon interest, interest on interest,

and proceeds from sale of the bond.

9. The essence of the answer is to price each bond’s cash flows using the spot interest rates.

The non-arbitrage price of bond A is

The market price of Bond B is 88.34, which is only 2 cents (2.3 basis points of market

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10.

10(a). Bond Valuation

On April 2, 2018 P0= PV of Coupons + PV of Face Value

10(b). (i) “Clean” or “Flat” Price = 102.5527– 1.495 = 101.0577