WESTERN MONEY MANAGEMENT INC.

Bond Valuation Robert Black and Carol Alvarez are vice-presidents of Western Money Management and co-directors of the companys pension fund management division. A major new client, the California League of Cities, has requested that Western present an investment seminar to the mayors of the represented cities, and Black and Alvarez, 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? ANS: The key features of a bond: Claims on assets and income Par Value Coupon interest rate Maturity Indenture Current Yield Bond Ratings

b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? ANS: Call Provision: A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date. Sinking Fund Provision: A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year. These provisions are making the bonds more risky.

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

d. How is the value of a bond determined? What is the value of a 10-year, $1000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent? ANS: The value of bond is found as the present value of an annuity (the interest payments) plus the present value of a lump sum (the principal). The bond is evaluated at the appropriate periodic interest rate over the number of periods for which interest payments are made. FV= $1000 n= 10 yrs CR= 10% MR= 10% [PMT= 1000 0.1= $100]

PVB= PMT (PVIFAi, n) +

PVB= 100 (PVIFA10%, 10) + PVB= 100 (6.1446) + 385.5 PVB= $999.96

[PVIFA10%, 10= 6.1446]

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 3 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a premium bond? ANS: FV= $1000 MR= 13% n= 10 yrs CR= 10% [PMT= 1000 0.1= $100]

PVB= PMT (PVIFAi, n) +

PVB= 100 (PVIFA13%, 10) + PVB= 100 (5.426) + 294.6 PVB= $837.2

[PVIFA13%, 10= 5.426]

[The value of the bond decreases.]

We now have a discount bond because the present value of the bond is below its par value.

(2) What would happen to the bonds value if inflation fell, and kd declined to 7 percent? Would we now have a premium or a discount bond?

ANS: FV= $1000

MR= 7%

n= 10 yrs

CR= 10% [PMT= 1000 0.1= $100]

PVB= PMT (PVIFAi, n) +

PVB= 100 (PVIFA7%, 10) + PVB= 100 (7.0236) + 508.3 PVB= $1210.7

[PVIFA7%, 10= 7.0236]

[The value of the bond increases.]

We now have a premium bond because the present value of the bond is above its par value.

(3) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent? (Hint: With a financial calculator, enter PMT, I, FV, and N, and then change (override) N to see what happens to the PV as the bond approaches maturity.) ANS: FV= $1000 MR= 13% n= 10 yrs CR= 10% [PMT= 1000 0.1= $100]

PVB= PMT (PVIFAi, n) +

PVB= 100 (PVIFA13%, 10) + PVB= 100 (5.426) + 294.6 PVB= $837.2

[PVIFA13%, 10= 5.426]

As the bond is a discount bond the value of the 10-year bond will increase over time, if the required rate of return remained at 13%, till it reaches maturity.

FV= $1000

MR= 7%

n= 10 yrs

CR= 10% [PMT= 1000 0.1= $100]

PVB= PMT (PVIFAi, n) +

PVB= 100 (PVIFA7%, 10) + PVB= 100 (7.0236) + 508.3 PVB= $1210.7

[PVIFA7%, 10= 7.0236]

As the bond is a premium bond the value of the 10-year bond will decrease over time, if the required rate of return remained at 7%, till it reaches maturity.

f. (1) What is the yield to maturity on a 10-year, 9 percent annual coupon, $1000 par value bond that sells for $887.00? That sells for $ 1134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between kd and the bonds coupon rate? ANS: FV= $1000 n= 10 yrs CR= 9% MV= $887.00

YTM=

[C= 1000 0.09 =90]

YTM=

= 0.1074 = 10.74%

FV= $1000

n= 10 yrs

CR= 9%

MV= $1134.20

YTM=

[C= 1000 0.09 =90]

YTM=

= 0.0718 = 7.18%

The market rate (kd) is higher than the coupon rate for a bond that sells at a discount and the market rate (kd) lower than the coupon rate for a bond that sells at a premium.

(2) What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.) ANS: Total return= Required rate of return= 10.74% Current Yield=

=0.1015= 10.15%

Capital gains/loss yield=

100

= = 11.3%

100

g. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10-year bond? Why? ANS: Interest rate (or price) risk: The risk of a decline in a bonds price due to an increase in interest rates. A 10-year bond has more interest rate risk because the longer the maturity of the bond, the more its price changes in response to a given change in interest rates. Suppose you bought a 10-year bond that yielded 10% or $100 a year. Now suppose interest rates on comparable risk bonds rose to 15%. You would be stuck with only $100 of interest for the next 10 years. On the other hand, had you bought a 1-year bond, you would have a low return for only 1 year. At the end of the year you would get your $1000 back and you could then reinvest it and receive 15% or $150 per year for the next 9 years. So risk is higher for 10-years bond.

h. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond? ANS: Reinvestment rate risk: The risk that a decline in interest rates will lead to a decline in income from a bond portfolio. A 1-year bond has more reinvestment rate risk because shorter the maturity of a bond, the lower the years when the relatively high old interest rate will be earned and sooner the funds will have to be reinvested at the new low rate.

i. How does the equation for valuing a bond change if semi-annual payments are made? Find the value of a 10-year, semi-annual payment, 10 percent coupon bond if nominal kd= 13%. ANS: For semi-annual payments: 1) FV= $1000 MR= 6.5%

; 2) ; 3)n
CR= 10% [PMT=

n= 20 yrs

PVB= PMT (PVIFAi, n) +

= $50]

PVB= 50 (PVIFA6.5%, 20) + PVB= 50 (11.032) + 283.8 PVB= $835.40

[PVIFA6.5%, 20= 11.032]

j. Suppose you could buy, for $1000, either a 10 percent, 10-year annual payment bond or a 10 percent, 10-year semiannual payment bond. They are equally risky. Which would you prefer? If $1000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond? ANS: The 10 percent, 10-year semiannual payment bond will be selected. FV= $1000 n= 10 yrs i= 10% [PMT= 1000 = $100]

PVB= PMT (PVIFAi, n) +

PVB= 100 (PVIFA10%, 10) + PVB= 100 (6.1446) + 385.5 PVB= $999.96

[PVIFA10%, 10= 6.1446]

k. Suppose a 10-year, 10 percent semiannual coupon bond with a par value of $1000 is currently selling for $1135.90, producing a nominal yield to maturity of 8 percent. However, the bond can be called after 4 years for a price of $1050. (1) What is the bonds nominal yield to call (YTC)? ANS: FV= $1050 n= 8 yrs MV= $1135.90 C= 1000 0.05=50 i= 5%

YTC=

YTC=

= 0.0359 = 3.59%

(2) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why? ANS: We are more likely to earn the YTC because if the going rate remains at YTM= 8% then the company could save 10% 8%= 2% or $20 per bond per year by calling them and replacing the 10% bonds with a new 8% issue. There would be cost to the company to refund the issue but the interest savings would probably be worth the cost. So the company would probably earn YTC= 7.18% rather than YTM= 8%.

l. Does the yield to maturity represent the promised or expected return on the bond? ANS: As the bond is being called back, the bondholder no longer gets the promised payments to maturity, in which case the calculated yield to maturity will be the expected return on the bond.

m. These bonds were rated AA- by S&P. Would you consider these bonds investment grade or junk bonds? ANS: The bond investment are Investment Grade Bonds because these bonds are rated higher than triple-B.

n. What factors determine a companys bond rating? ANS: Factors that determine a companys bond rating: A greater reliance on equity as opposed to debt in financing the firm Profitable operations A low variability in past earnings Large firm size Little use of subordinated debt

o. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments? ANS: