Self-test Problems

Problem 1: Bond valuation

Lahey Industries has outstanding a $1,000 par-value bond with an 8% coupon interest rate. The bond
has 12 years remaining to its maturity date.
a. If interest is paid annually, find the value of the bond when the required return is
(1) 7%
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 1,000 ∗ 8%
= 80
𝐼 1
𝐵0 = ∗ [1 − ] + 𝑀 ∗ 1/(1 + 𝑟𝑑 )𝑛
𝑟𝑑 (1 + 𝑟𝑑 )𝑛
80 1
𝐵0 = ∗ [1 − ] + 1,000 ∗ 1/(1 + 7%)12
7% (1 + 7%)12
𝐵0 = (1,142.86 ∗ 0.556) + (1,000 ∗ 0.444)
𝐵0 = 635.43 + 444
𝐵0 = 1,079.43
(2) 8%, and
80 1
𝐵0 = ∗ [1 − ] + 1,000 ∗ 1/(1 + 8%)12
8% (1 + 8%)12
𝐵0 = (1,000 ∗ 0.603) + (1,000 ∗ 0.397)
𝐵0 = 603 + 397
𝐵0 = 1,000
(3) 10%.
80 1
𝐵0 = ∗ [1 − ] + 1,000 ∗ 1/(1 + 10%)12
10% (1 + 10%)12
𝐵0 = (800 ∗ 0.681) + (1,000 ∗ 0.319)
𝐵0 = 544.80 + 319
𝐵0 = 863.80

b. Indicate for each case in part a whether the bond is selling at a discount, at a premium, or at its
par value.
a. At 7%, the bond is selling at a premium
b. At 8%, the bond is selling at par value
c. At 10%, the bond is selling at a discount

c. Using the 10% required return, find the bond’s value when interest is paid semiannually.
80
1 10% 12∗2
𝐵0 = 2 ∗ [1 − ] + 1,000 ∗ 1/(1 + ( ))
10% 10% 12∗2 2
(1 + ( 2 ))
40 1
𝐵0 = ∗ [1 − ] + 1,000 ∗ 1/(1 + 5%)24
5% (1 + 5%)24
𝐵0 = (800 ∗ 0.690) + (1,000 ∗ 0.310)
𝐵0 = 552 + 310
 𝐵0 = 862

Problem 2: Bond yields

Elliot Enterprises’ bonds currently sell for $1,150, have an 11% coupon interest rate and a $1,000 par
value, pay interest annually, and have 18 years to maturity.
a. Calculate the bonds’ current yield.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 1,000 ∗ 11%
= 110
𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒
110
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
1,150
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 9.57%

b. Calculate the bonds’ yield to maturity (YTM).

𝑢𝑠𝑖𝑛𝑔 9%
110 1
1,150 = ∗ [1 − ] + 1,000 ∗ 1/(1 + 9%)18
9% (1 + 9%)18
1,150 = (1,222.22 ∗ 0.788) + (1,000 ∗ 0.212)
1,150 = 963.11 + 212
1,150 < 1,175.11
𝑢𝑠𝑖𝑛𝑔 10%
110 1
1,150 = ∗ [1 − ] + 1,000 ∗ 1/(1 + 10%)18
10% (1 + 10%)18
1,150 = (1,100 ∗ 0.820) + (1,000 ∗ 0.180)
1,150 = 902 + 180
1,150 > 1,082
The bond′ s yield to maturity must be between 9% and 10% because 1,150 is lesser than 1,175.11
value at 9% and 1,150 is greater than the 1,082 value at 10%

c. Compare the YTM calculated in part b to the bonds’ coupon interest rate and current yield
(calculated in part a). Use a comparison of the bonds’ current price and par value to explain
these differences.
The exact yield to maturity, computed using excel, is 9.27%. The 9.27% yield to maturity is
lower than the 11% coupon interest rate and the 9.57% current yield. This means that the
bond is selling at a premium. Its current market price is also higher than the par value.

Bond Valuation

1. Bond Yields. A 30-year Treasury bond is issued with par value of $1,000, paying interest of $80
per year. If market yields increase shortly after the T-bond is issued, what happens to the
bond’s:
a. coupon rate
𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
=
𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
 80
=
1,000
= 0.08 𝑜𝑟 8% 𝑡ℎ𝑖𝑠 𝑚𝑒𝑎𝑛𝑠 𝑡ℎ𝑎𝑡 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝑟𝑒𝑚𝑎𝑖𝑛𝑠 𝑢𝑛𝑐ℎ𝑎𝑛𝑔𝑒𝑑.

b. Price
When the market yields, the discounting rate rises, and thus the present value of
the bond payments falss. When the present value of the bond payment falss, the price
of the bond falls.

c. yield to maturity
The bond′ s yield to maturity will be higher at a lower price. Moreover, in connection
to the bond′ s price, if the market yields, the yield to maturity also rises.

d. current yield
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡/𝑐𝑜𝑢𝑝𝑜𝑛
=
𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
Since the coupon interest remains the same, the current yield will rise if the
bond price falls. Consequently, if the market yields, the current yield rises.

2. Bond Yields. If a bond with par value of $1,000 and a coupon rate of 8 percent is selling at a
price of $970, is the bond’s yield to maturity more or less than 8 percent? What about the
current yield?
𝑇ℎ𝑒 𝑏𝑜𝑛𝑑′ 𝑠 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑚𝑢𝑠𝑡 𝑏𝑒 ℎ𝑖𝑔ℎ𝑒𝑟 𝑡ℎ𝑎𝑛 8% 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡𝑙𝑦, 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
𝑖𝑠 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑎𝑡 𝑎 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡. 𝐼𝑓 𝑤𝑒 𝑐𝑜𝑚𝑝𝑢𝑡𝑒 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑:
𝑐𝑜𝑢𝑝𝑜𝑛
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
1,000 ∗ 8%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
970
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 8.25% 𝑖𝑡 𝑖𝑠 ℎ𝑖𝑔ℎ𝑒𝑟 𝑡ℎ𝑎𝑛 8%

3. Bond Yields. A bond with par value $1,000 has a current yield of 7.5 percent and a coupon rate
of 8 percent. What is the bond’s price?
𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 1,000 ∗ 8%
𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 80
80
7.5% =
𝑃𝑟𝑖𝑐𝑒
𝑃𝑟𝑖𝑐𝑒 = 1,066.67

4. Bond Pricing. A 6-year Circular File bond pays interest of $80 annually and sells for $950. What
is its coupon rate, current yield, and yield to maturity?
𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 = 80/1,000
𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 = 8%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 80/950
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 0.0842 𝑜𝑟 8.42%
𝑌𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 = 9.12%
𝑌𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 = 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑑 𝑢𝑠𝑖𝑛𝑔 𝑒𝑥𝑐𝑒𝑙

5. Bond Pricing. If Circular File (see question 4) wants to issue a new 6-year bond at face value,
what coupon rate must the bond offer?
 If Circular File wants to sell the bond at par then the coupon rate must be equal to the
yield to maturity which is 9.12%. If the company wishes to sell at premium, they may
increase the coupon rate higher than the yield to maturity rate.

6. Bond Yields. An AT&T bond has 10 years until maturity, a coupon rate of 8 percent, and sells for
$1,050.
a. What is the current yield on the bond?
1,000 ∗ 8%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
1,050
80
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
1,050
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 0.0762 𝑜𝑟 7.62%

b. What is the yield to maturity?

𝑌𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 = 7.28%
𝑌𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 = 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑑 𝑢𝑠𝑖𝑛𝑔 𝑒𝑥𝑐𝑒𝑙

7. Coupon Rate. General Matter’s outstanding bond issue has a coupon rate of 10 percent and a
current yield of 9.6 percent, and it sells at a yield to maturity of 9.25 percent. The firm wishes to
issue additional bonds to the public at par value. What coupon rate must the new bonds offer in
order to sell at par?
If the bond is selling at par value, its coupon rate must be equal to the yield of maturity
Therefore, the coupon rate must be 9.25%.

8. Bond Prices and Returns. One bond has a coupon rate of 8 percent, another a coupon rate of 12
percent. Both bonds have 10-year maturities and sell at a yield to maturity of 10 percent. If their
yields to maturity next year are still 10 percent, what is the rate of return on each bond? Does
the higher coupon bond give a higher rate of return?
𝐶𝑜𝑚𝑝𝑢𝑡𝑒𝑑 𝑢𝑠𝑖𝑛𝑔 𝑒𝑥𝑐𝑒𝑙:
𝑎𝑡 8% 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒
𝑌𝑒𝑎𝑟 1 = 877.11
𝑌𝑒𝑎𝑟 2 = 884.82
80 + (884.82 − 877.11)
𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
877.11
𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 0.0999 𝑜𝑟 10%
𝑎𝑡 12% 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒
𝑌𝑒𝑎𝑟 1 = 1,122.89
𝑌𝑒𝑎𝑟 2 = 1,115.18
120 + (1,115.18 − 1,122.89)
𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
1,122.89
𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 0.0100 𝑜𝑟 10%
Both coupon rates have the same rate of return

9. Bond Returns.
a. If the AT&T bond in problem 6 has a yield to maturity of 8 percent 1 year from now,
what will its price be?
If yield to maturity is 8%, the price will be 1,000.
 b. What will be the rate of return on the bond?
80 + (1,000 − 1,100)
𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
1,100
𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = −0.0182 𝑜𝑟 − 1.82%

c. If the inflation rate during the year is 3 percent, what is the real rate of return on the
bond?
1 + nominal interest rate
real return = −1
1 + inflation rate
0.9818
real return = −1
1.03
real return = −0.0467 or − 4.68%

10. Bond Pricing. A General Motors bond carries a coupon rate of 8 percent, has 9 years until
maturity, and sells at a yield to maturity of 9 percent.
a. What interest payments do bondholders receive each year?
At 1,000 par value with 8% coupon interest, the bondholder receive 80
annual interest payments.

b. At what price does the bond sell? (Assume annual interest payments.)
1,000
𝑝𝑟𝑖𝑐𝑒 = 80 ∗ (1 − (1/(1 + 0.09)9 )/0.09) + )
(1 + 0.09)9
𝑝𝑟𝑖𝑐𝑒 = 80 ∗ 6.515232 + 543.933743
𝑝𝑟𝑖𝑐𝑒 = 1,065.15

c. What will happen to the bond price if the yield to maturity falls to 7 percent?
If the yield to maturity is for example 6%, the bond price will rise. The bond will
sell for 1,136.03.

--NOTHING FOLLOWS—