Strictly for course AB1201 internal circulation only.

Nanyang Business School

AB1201 Financial Management
Tutorial 4: Bonds and their Valuation
(Common Questions)
Questions 1 to 4 will be presented by students while Questions 5 and 6 will be presented by
instructors.

1) Indicate which of the following actions will increase or decrease a bonds yield to maturity:
a) The bonds price increases.
b) The bond is downgraded by rating agencies.
c) A change in the bankruptcy code makes it more difficult for bondholders to receive payments
in the event the firm declares bankruptcy.
d) The economy seems to be shifting from a boom to a recession. Discuss the effects of the
firms credit strength in your answer.

2) Interest rate risk. If interest rates rise after a bond issue, what will happen to the bonds price
and YTM? Does the time to maturity affect the extent to which interest rate changes affect the
bonds price? Why?
a) Consider two bonds with an 8% annual coupon and a $1,000 par value and both issued at its
par value. One bond has a 5-year maturity, while the other has a 20-year maturity. If YTM rise
to 15% immediately after the issue, what would be the value of the 5-year bond and the 20-
year bond?
b) If you bought both bonds when there were issued and hold them to maturity, what yield will
you get?
c) If you bought the bonds after the YTM has increased and hold them to maturity, what yield
will you get?

3) Semi-annual bond. What is the YTM on a 10-year, 10% semiannual coupon bond, if it is selling
at $834.72?
Hint 1: Semi-annual bonds are bonds where the coupons are paid every semi-annually. Therefore,
a 10% semi-annual coupon bond will pay $50 every half-yearly.
Hint 2: The YTM is a nominal rate.

4) Current yield, capital gains yield, and yield to maturity. Hooper Printing Inc. has bonds
outstanding with 9 years left to maturity. The bonds have an 8 percent annual coupon rate and
were issued 1 year ago at their par value of $1,000, but due to changes in interest rates, the
bonds market price has fallen to $901.40. The capital gains yield last year was -9.86 percent.
a) What is the yield to maturity?
b) For the coming year, what is the expected current yield and the expected capital gains yield?
c) If you bought the bond at $901.40, and sell it at the end of the year, will the actual realized
yields (capital gains yields and current yield) be equal to the expected yields in part b if
interest rates change at the end of the year? If not, how will they differ?

5) Semi-annual bond vs. annual bond. Company Leggo has two bonds outstanding, a 5-year, 10%
annual coupon bond, and a 5-year, 10% semiannual coupon bond. Suppose the semi-annual bond
is selling at $900, what should the annual bonds price be?

6) Bond valuation. Bond X is noncallable, has 20 years to maturity, a 9 percent annual coupon,
and a $1,000 par value. Your required return on Bond X is 10 percent, and if you buy it you plan
to hold it for 5 years. You, and the market, have expectations that in 5 years the yield to maturity

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on a 15-year bond with similar risk will be 8.5 percent. How much should you be willing to pay
for Bond X today? (Hint: You will need to know how much the bond will be worth at the end of
5 years.)

__________________________________________________________________________
Self-practice Questions

Question 1

LinQTech Company has two bond issues outstanding, both have par value of $1,000 and both sell
for $806.13. The first issue has a 10% annual coupon rate and 15 years to maturity, while the
second has the same YTM and only 5 years to maturity. The first issue pays coupon annually while
the second pays semiannually. What is the annual coupon rate on the second issue?

Question 2

Bond ABC is a 10-year, $1,000 par value bond which pays a 6% coupon with quarterly payments
during its first five years (you receive $15 a quarter for the first 20 quarters). During the remaining
five years the security has an 8% quarterly coupon (you receive $20 a quarter for the second 20
quarters). At the end of 10 years (40 quarters) you will also receive the par value.

Bond DEF is another 10-year bond issued by the same company, and it has a 10% semiannual
coupon. This bond is selling at its par value $1,000 and has the same risk as the bond ABC.
Given this information, what should be the price of the bond ABC?

Question 3

A company's bond has a coupon rate of 6.00% per year and has 28 years remaining until maturity.
The company's bonds pay interest semi-annually and has $1,000 par value. Due to a cash flow
problem, the company will be unable to pay the coupon payments for periods 7, 8, 9, and 10. These
missed payments will be repaid in one lump sum ($120) when the bond matures, without extra
interest. If the Yield to Maturity (YTM) on similar bonds is 8%, what is the intrinsic value of this
bond?

Answers to self-practice questions:

Question 1:

Note that this question differs from Q5 in the main tutorial. In this question, given that the two
bonds have different maturity, they cannot have the same effective interest rates. In this question, it
states that they have the same YTM, i.e., same nominal interest rates, after taking into account
compounding, they will have different effective interest rates.

Step 1: Find YTM using information on first issue

100 1 1,000
806.13 = [1 ] +
(1 + )15 (1 + )15

YTM = 13.00%

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Step 2: Based on calculated YTM, find coupon on second issue

2 1 1,000
806.13 = [1 52
]+
0.13/2 (1 + 0.13/2) (1 + 0.13/2)52

PMT / 2 = $38.03

PMT = 2 x 38.03 = $76.06

Step 3: Find annual coupon rate on second issue

The annual coupon rate of the second issue is (76.06 / 1000) x 100 = 7.606%

Question 2:

Step 1: Find the periodic interest rate on ABC.

Since the securities are of equal risk and maturity, they must have the same effective annual rate.
Since DEF is a 10-year bond is selling at par, its nominal yield is 10%, the same as its coupon
rate.
DEFs effective annual rate is (1 + 0.10/2)2 1 = 10.25%.
Since ABC has quarterly payments, its periodic rate = (1.1025)0.25 1 = 2.4695%

Step 2: Price of ABC

Price of ABC = PV of Annuity (20 payments of $15) + PV of Annuity (next 19 payments of $20)
+ PV of (last $20 + $1,000)
15 1 1 20 1 1020
= 0.024695 (1 )+ { (1 )} +
1.02469520 1.02469520 0.024695 1.02469519 1.02469540

= 234.51 + 184.42 + 384.42

= $ 803.36

Question 3

Periodic interest rate = 8%/2 = 4%

Total number of periods = 28*2 = 56
30 30 0 0 30
Value of bond = (1+0.04) + + (1+0.04)6
+ (1+0.04)7 + + (1+0.04)10 + (1+0.04)11 + +
30 30+120+1000
(1+0.04)55
+ (1+0.04)56
= $705

You can use your financial calculators CF function to help you to arrive at the final answer.
CF0 = 0
CF1 = 30, Frequency = 6
CF2 = 0, Frequency = 4
CF3 = 30, Frequency = 45
CF4 = 1150, Frequency = 1
I = 4%
NPV = ?

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