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3 Chapter 5. Mini Case
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5 Situation
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7 Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the com
8 pension fund management division. A major new client, the Northwestern Municipal Alliance, has requested that Mutual
present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual
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presentation, have asked you to help them by answering the following questions. Because the Boeing Company operate
10 the league's cities, you are to work Boeing into the presentation.
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12 a. What are the key features of a bond? Answer: See Chapter 5 Mini Case Show
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14 b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?
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16 Call Provisions and Sinking Funds
17 A call provision that allows the issuer to redeem the bond at a specified time before the maturity date. If interest rates fa
18 issuer can refund the bonds and issue new bonds at a lower rate. Because of this, borrowers are willing to pay more an
19 require more on callable bonds.
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In a sinking fund provision, the issuer pays off the loan over its life rather than all at the maturity date. A sinking fund re
22 risk to the investor and shortens the maturity. This is not good for investors if rates fall after issuance.
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24 c. How is the value of any asset whose value is based on expected future cash flows determined? Answer: See Chapter
25 Show
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27 d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annu
28 its required rate of return is 10 percent?
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30 Finding the "Fair Value" of a Bond
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32 First, we list the key features of the bond as "model inputs":
33 Years to Mat: 10
34 Coupon rate: 3%
35 Annual Pmt: $ 30.00
36 Par value = FV: $ 1,000.00
37 Going rate, rd: 2.24%
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39 The easiest way to solve this problem is to use Excel's PV function. Click fx, then financial, then PV. Then fill in the men
40 shown in our snapshot in the screen shown just below.
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60 Value of bond = $1,067.75 Thus, this bond sells at its par value. That situation always exists if the going rate is eq
61 coupon rate.
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63 The PV function can only be used if the payments are constant, but that is normally the case for bonds.
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65 e. (1.) What would be the value of the bond described in Part d if, just after it had been issued, the expected inflation rate
66 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a premium bond
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69 We could simply go to the input data section shown above, change the value for r from 10% to 13%. You can set up a da
70 show the bond's value at a range of rates, i.e., to show the bond's sensitivity to changes in interest rates. This is done b
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72 Bond Value
To make the data table, first type the headings, then type the rates in cells
73 Going rate, r: $1,068 column. Since the input values are listed down a column, type the formula
74 0.00% above the first value and one cell to the right of the column of values (this i
75 2.24% that the formula in B73 actually just refers to the bond pricing formula abov
76 4.00% Select the range of cells that contains the formulas and values you want to
(A73:B78). Then click Data, What-If-Analysis, and then Data Table to get the
77 5.24% The input data are in a column, so put the cursor on "column input cell" an
78 10.00% cell with the value for r (B37), then Click OK to complete the operation and
79 table.
80 We can use the data table to construct a graph that shows the bond's
81 sensitivity to changing rates.
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84 Interest Rate Sensitivity of a 10-Year Disney Bond
85 Value at 2.24% Value at 5.24%
86 $12
87 $10
88 $8
$6
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$4
90 $2
91 $0 Put B37 here.
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96 (2.) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 percent
97 remained at 7 percent? Would we now have a premium or a discount bond in either situation? You pick a rate.
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99 Value of Bond in Given Year:
100 N 1.00% 2.24% 5.24%
101 0 $1,189.87 $1,067.75 $827.36
102 1 $1,171.73 $1,061.64 $840.89
103 2 $1,153.40 $1,055.38 $855.14
104 3 $1,134.89 $1,048.99 $870.14
105 4 $1,116.19 $1,042.45 $885.94
106 5 $1,097.30 $1,035.76 $902.58
107 6 $1,078.23 $1,028.92 $920.10
108 7 $1,058.96 $1,021.93 $938.56
109 8 $1,039.50 $1,014.78 $957.99
110 9 $1,019.85 $1,007.47 $978.45
111 10 $1,000.00 $1,000.00 $1,000.00
112 You pick the rate for
113 Rates fall to 1% Your choice:
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Value of the bond over time
Rates stay the same at 2.24%
115 Rates increase to 5.24%
116 Your choice at 20%
117 $1,400.00 Resulting bond p
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$1,200.00
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Price

120 $1,000.00
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122 $800.00
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$600.00
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125 $400.00
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127 $200.00
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$0.00
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1 2 3 4 5 6 7 8 9 10 11
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Years to maturity
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If rates fall, the bond goes to a premium, but it moves towards par as maturity approaches. The reverse hold if rates rise
135 bond sells at a discount. If the going rate remains equal to the coupon rate, the bond will continue to sell at par. Note th
136 above graph assumes that interest rates stay constant after the initial change. That is most unlikely--interest rates fluctu
137 do the prices of outstanding bonds.
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139 Yield to Maturity (YTM)
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141 f. (1.) What is the yield to maturity on a 10-year, 9 percent annual coupon, $1,000 par value bond that sells for $887.00? T
142 for $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between
143 bond's coupon rate? What is the yield-to-maturity of the bond?
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145 Use the Rate function to solve the problem.
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147 Years to Mat: 10
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148 Coupon rate: 9%
149 Annual Pmt: $90.00 Going rate, r =YTM: 10.91% See RATE fun
150 Current price: $887.00
151 Par value = FV: $1,000.00
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153 (2.) What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is
154 maturity and the company does not default on the bond.)
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156 Current and Capital Gains Yields
157 The current yield is the annual interest payment divided by the bond's current price. The current yield provides informat
158 regarding the amount of cash income that a bond will generate in a given year. However, it does not account for any cap
159 or losses that will be realized if the bond is held to maturity or call.
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161 Simply divide the annual interest payment by the price of the bond. Even if the bond made semiannual payments, we wo
162 the annual interest.
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164 Par value $1,000.00
165 Coupon rate: 9% Current Yield = 10.15%
166 Annual Pmt: $90.00
167 Current price: $887.00
168 YTM: 10.91%
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170 The current yield provides information on a bond's cash return, but it gives no indication of the bond's total return. To se
171 consider a zero coupon bond. Since zeros pay no coupon, the current yield is zero because there is no interest income.
172 the zero appreciates through time, and its total return clearly exceeds zero.
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174 YTM = Current Yield + Capital Gains Yield
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177 Capital Gains Yield = YTM - Current Yield
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179 Capital Gains Yield = 10.91% - 10.15%
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181 Capital Gains Yield = 0.76%
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184 g. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, sem
185 payment, 10 percent coupon bond if nominal rd = 13%.
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187 Bonds with Semiannual Coupons
188 Since most bonds pay interest semiannually, we now look at the valuation of semiannual bonds. We must make three m
189 to our original valuation model: (1) divide the coupon payment by 2, (2) multiply the years to maturity by 2, and (3) divide
190 nominal interest rate by 2.
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192 Use the Rate function with adjusted data to solve the problem.
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194 Periods to maturity = 10*2 = 20
195 Coupon rate: 10%
196 Semiannual pmt = $100/2 = $50.00 PV = $834.72
197 Future Value: $1,000.00
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198 Periodic rate = 13%/2 = 6.5%
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200 Note that the bond is now more valuable, because interest payments come in faster.
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203 Excel Bond Functions
204 Suppose today's date is January 1, 2014, and the bond matures on December 31, 2023
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206 Settlement (today) 1/1/2014
207 Maturity 12/31/2023
208 Coupon rate 10.00%
209 Going rate, r 13.00%
210 Redemption (par value) 100
211 Frequency (for semiannual) 2
212 Basis (360 or 365 day year) 0
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215 Value of bond = $83.4737 or $834.74
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217 Notice that you could choose a current date that is between coupon payments, and the PRICE function will calculate the
218 price. See the example below.
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221 Settlement (today) 3/25/2014
222 Maturity 12/31/2023
223 Coupon rate 10.00%
224 Going rate, r 13.00%
225 Redemption (par value) 100
226 Frequency (for semiannual) 2
227 Basis (360 or 365 day year) 0
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229 Value of bond = $83.6307 or $836.31
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231 This is the value of the bond, but it does not include the accrued interest you would pay. The ACCRINT function will calc
232 accrued interest, as shown below.
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234 Issue date 1/1/2014
235 First interest date 6/30/2014
236 Settlement (today) 3/25/2014
237 Maturity 12/31/2023
238 Coupon rate 10.00%
239 Going rate, r 13.00%
240 Redemption (par value) 100
241 Frequency (for semiannual) 2
242 Basis (360 or 365 day year) 0
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244 Accrued interest = $2.3333 or $23.33
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247 Suppose the bond's price is $1,150. You can also calculate the yield using the YIELD function, as shown below.
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249 Curent price $ 1,150.00
250 Settlement (today) 1/1/2014
251 Maturity 12/31/2023
252 Coupon rate 10.00%
253 Redemption (par value) 100
254 Frequency (for semiannual) 2
255 Basis (360 or 365 day year) 0
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257 Yield 7.81%
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h. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $1,000 is currently selling for $1,135.90, p
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nominal yield to maturity of 8 percent. However, the bond can be called after 5 years for a price of $1,050.
262 (1.) What is the bond's nominal yield to call (YTC)?
263 (2.) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why?
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265 Yield to Call
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The yield to call is the rate of return investors will receive if their bonds are called. If the issuer has the right to call the b
267 if interest rates fall, then it would be logical for the issuer to call the bonds and replace them with new bonds that carry a
268 coupon. The yield to call (YTC) is found similarly to the YTM. The same formula is used, but years to maturity is replace
269 to call, and the maturity value is replaced with the call price.
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271 Use the Rate function to solve the problem.
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273 Number of semiannual periods to call: 10
274 Seminannual coupon rate: 5% Semiannual Rate = I = YTC =
275 Seminannual Pmt: $50.00 Annual nominal rate =
276 Current price: $1,135.90
277 Call price = FV $1,050.00
278 Par value $1,000.00
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281 i. Write a general expression for the yield on any debt security (rd) and define these terms: real risk-free rate of interest
282 premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Answer: See Chapte
283 Case Show.
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287 j. Define the nominal risk-free rate (rRF). What security can be used as an estimate of rRF? Answer: See Chapter 5 Mini C
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290 k. Describe a way to estimate the inflation premium (IP) for a T-Year bond. Answer: See Chapter 5 Mini Case Show.
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293 l. What is a bond spread and how is it related to the default risk premium? How are bond ratings related to default risk?
294 factors affect a company’s bond rating? Answer: See Chapter 5 Mini Case Show.
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297 m. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10-y
298 Why?
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Interest Rate Risk is the risk of a decline in a bond's price due to an increase in interest rates. Price sensitivity to interes
302 greater (1) the longer the maturity and (2) the smaller the coupon payment. Thus, if two bonds have the same coupon, th
303 the longer maturity will have more interest rate sensitivity, and if two bonds have the same maturity, the one with the sm
304 coupon payment will have more interest rate sensitivity.
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308 Your Choice of Maturity 10-Yr Maturity
309 Years to Mat: 10 Rate Price Rate Price
310 Coupon rate: 10% $966.65 $946.77
311 Annual Pmt: $100.00 5.0% 5.0%
312 Current price: $946.77 7.0% 7.0%
313 Par value = FV: $1,000.00 10.0% 10.0%
314 YTM = 10.9% 13.0% 13.0%
315 15.0% 15.0%
316 Years to Mat: 1
317 Coupon rate: 10% Colu

318 Annual Pmt: $100.00 10 Yr. versus 1 Yr. Colu

$1,400.00 You
319 Current price: $991.88
320 Par value = FV: $1,000.00 $1,300.00
321 YTM = 10.9%
$1,200.00
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323 $1,100.00

324 Enter your choice $1,000.00

325 for years to $900.00
326 maturity: 5
327 $800.00
328 $700.00
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5.0% 7.0% 10.0% 13.0%
330 YTM
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335 As the interst rate goes from 5% to 15%, the price changes are bigger for the 10-year bond.
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338 rd 10-Year P Change 1-Year P Change
339 5.0% $1,048 $1,386
340 4.8% 38.6%
341 10.0% $1,000 $1,000
342 4.5% 33.5%
343 15.0% $957 $749
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346 n. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond? Answer: Se
347 Mini Case Show.
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350 o. How are interest rate risk and reinvestment rate risk related to the maturity risk premium? Answer: See Chapter 5 Mi
351 Show.
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354 p. What is the term structure of interest rates? What is a yield curve?
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356 The term structure describes the relationship between long-term and short-term interest rates. Graphically, this relation
357 shown in what is known as the yield curve. See the hypothetical curve below.
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360 Hypothetical Inputs See to right for actual date us
361 Real risk free rate 3.00%
362 Expected inflation of 5% for the next 1 years.
363 Expected inflation of 6% for the next 1 years.
364 Expected inflation of 8% thereafter.
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366 Hypothetical Treasury Yield Curve
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Interest Rate

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14.00%
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12.00%
MRP
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10.00%
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8.00%
375 Inflation
Premium
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6.00%
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4.00%
380 Real Risk
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2.00% Free Rate
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0.00%
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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
385 Maturity
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389 The yield is upward sloping due to increasing expected inflation and an increasing maturity risk premium
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393 q. Briefly describe bankruptcy law. If a firm were to default on the bonds, would the company be immediately liquidated
394 the bondholders be assured of receiving all of their promised payments? Answer: See Chapter 5 Mini Case Show.