MGMT 526

Assignment # 2

Background:

Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company
and co-directors of the company's pension fund management division. A major new client, the
Northwestern Municipal Alliance, has requested that Mutual of Seattle present an investment
seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the
actual presentation, have asked you to help them by answering the following questions.

a. What are the key features of a bond?

Par value or face value, coupon rate, maturity, issue date, default risk

b. What are call provisions? Do these provisions make bonds more or less desirable
from the standpoint of the investor?

A call provisions is a provision in a bond contract that gives the issuing corporation the right to
redeem the bonds under specified terms prior to the normal maturity date. The call privilege is
valuable to the firm but potentially detrimental to the investor, especially if the bonds were
issued in a period where interest rates were cyclically high. Meaning that bonds with call
provisions are riskier than those without.

c. How is the value of an asset whose value is based on expected future cash flows
determined?

The value of an asset is calculated by Discount Cash Flow method whose value is based on
the series of future cash flows. It’s determined by discounting all future cash flows back to
time period zero and adding them together.

d. How is the value of a bond determined? What is the value of a 10yr, $1000 par
value bond with a 10% annual coupon if its required rate of return is 10%?

The value of a bond is determined by the selling price of today’s PV

N PMT I FV PV
10 100 10 1000 1,000

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 rose by 4.6% points causing
investors to require a 14.6% return? Would we now have a discount or
premium bond?

N PMT I FV PV

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 10 100 14.6 1000 -765.57
Discount bond

2) What would happen to the bond’s value if inflation fell, and r d declined to
5.2%? Would we now have a discount or premium bond?

N PMT I FV PV
10 100 5.2 1000 -1,367.07
Premium bond

3) What would happen to the value of the 10 year bond over time if the
required rate of return remained at 13%, or if it remained at 7%?

At maturity, the value of any bond must equal its par value, plus any accrued interest.
Therefore, if interest rates remained constant over time, a bond’s value must move
toward its par value as the maturity date approaches. If the ROR remained at 13% the
value of the bond would drop below par and sell at a discount. If ROR remained at 7%
the value of the bond would rise above par and sell at a premium.

f.
1) What is the yield to maturity on a 10 year, 5%, annual coupon, $1000 par
value bond that sells for $887.00?

N PMT I FV PV
10 50 6.58 1000 -887

That sells for $1,134.20?

N PMT I FV PV
10 50 3.39 1000 -1134.20

What does the fact that a bond sells at a discount or at a premium tell you
about the relationship between rd and the bond’s coupon rate?

The bond will be selling at par if the coupon rate and YTM are equal, if the
coupon rate is more than YTM then the bond will be selling at premium, and if the
coupon rate is lesser than the YTM then the bond will be selling at discount.

2) What are the total return, the current yield, and the capital gains yield for
the discount bond? The below formulas are hints: I want you to give me the
numbers.

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 YTM = Current yield + Capital gains yield

6.58%= YTM Discount Bond

Current Yield = Annual Coupon PMT / Current Price

$50/$887 = 5.64%

Capital Gains Yield = YTM – Current Yield

6.58-5.64 =0.94%

Expected Total Return = YTM = Exp Current YLD + Exp Cap Gains YLD

6.58% = 5.64% (coupon PMTs) + 0.94%(Price increase as we approach maturity)

g. What is the interest rate (or price) risk? Which bond has more interest rate risk, an
annual payment 1 year bond or 10 year bond? Why?

Interest rate risk is the threat that interest rates will rise causing the bond’s price to fall. A
10 year bond will have more interest rate risk than a 1 year bond due to the fact there is
more time and more payments for them to be affected by rising interest rates.

h. What is reinvestment rate risk? What has more reinvestment rate risk, a 1yr bond
or a 10yr bond?

Reinvestment rate risk is defined as the risk that cash flows (interest plus principal
repayments) will have to be reinvested in the future at rates lower than today's rate.
Since the coupon payments are significantly less than the principal amount, the
reinvestment rate risk on a long-term bond is significantly less than on a short-term bond.
1 year bonds have more reinvestment rate risk than 10 year bonds.

i. How does the equation for valuing a bond change if semiannual payments are
made?

You must multiply the years by 2 to get your N value. Then you divide the nominal rate by
2 to get the periodic rate and divide annual INT by 2 to get PMT.

Find the value of a 10yr, semiannual payment, and 9% coupon bond if nominal rate
is 13%.

N PMT I FV PV
20 45 6.5 1000 -779.63

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 j. Suppose you could buy a, for $1000, either a 9%, 10yr, annual payment bond or a
9%, 10yr, semiannual payment bond. They are equally risky. Which would you
prefer?

N PMT I FV PV

N PMT I FV PV

I would prefer the semiannual payment because the payments are made earlier and they
provide the opportunity to make further decisions. I would like to have the chance to build
up equity quicker and then earn more return by in turn using the money for future
investments.

k. Suppose you could buy a 10yr, 10%, semiannual bond with par value of $1000 is
selling for $1135.90, producing a nominal yield to maturity of 8%. However, the
bond can be called after 5 years for a price of $1,080.

1) What is the bond’s nominal yield to call (YTC)?

N PMT I FV PV
20 50 8.48% 1080 -1135.90

2) If you bought this bond, do you think you would be more likely to earn the
YTM or the YTC? Why?

YTM: N=20, PMT= 40, FV= 1,000, PV= -1,135.90, CPT I = 6.16

You are more likely to earn the YTM because YTC is greater and YTM is a
discount bond and we are in a rising rates environment

l. Boeing’s bonds were issued with a yield to maturity of 7.5%. Does the YTM
represent the promised or expected return on the bond?

This represents a promised rate of return, which is the return that investors will receive if
all the promised payments are made.

m. Boeing’s bonds were rated AA by S&P. Would you consider these bonds
investment grade or junk bonds?

Investment grade A bonds. Triple-A double-A, single-A, and triple-B bonds are considered
investment grade.

n. What factors determine a company’s bond rating?

Financial performance, determined by ratios such as the debt, TIE, FCC and current
ratios, provisions in the bond contract: Secured vs. Unsecured debt, Senior vs.
Subordinated debt, guarantee provisions, sinking fund provisions, debt maturity, earnings
stability, regulatory environment, potential product liability, accounting policy

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