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Business-Finance Tutorial 4 Answer

Business-Finance Tutorial 4 Answer

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Published by: Chia Kong Haw on Dec 23, 2010
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ABMF4024 BUSINESS FINANCETutorial 4 Answer November 1, 2010
Question 1
What are the key features of a bond?1.
Par or face value
. We generally assume a $1,000 par value, but par can be anything, and often $5,000 or more is used. With registeredbonds, which are what are issued today, if you bought $50,000 worth,that amount would appear on the certificate.2.
Coupon rate
. The dollar coupon is the ³rent´ on the money borrowed,which is generally the par value of the bond. The coupon rate is theannual interest payment divided by the par value, and it is generally setat the value of k on the day the bond is issued. To illustrate, therequired rate of return on one of southern bell¶s bonds was 11 percentwhen they were issued, so the coupon rate was set at 11 percent. If the company were to float a new issue today, the coupon rate would beset at the going rate today (September 1999), which would be around7.7 percent.3.
Maturity
. This is the number of years until the bond matures and theissuer must repay the loan (return the par value). The southern bellbonds had a 30-year maturity when they were issued, but the maturitydeclines by 1 year each year after their issue.4.
Call provision
. Most bonds (except U.S. Treasury bonds) can becalled and paid off ahead of schedule after some specified ³callprotection period.´ Generally, the call price is above the par value bysome ³call premium.´ We will see that companies tend to call bonds if interest rates decline after the bonds were issued, so they can refundthe bonds with lower interest bonds. This is just like homeownersrefinancing their mortgages if mortgage interest rates decline. The callpremium is like the prepayment penalty on a home mortgage. Thesouthern bell bond issue did not contain a call provision.5.
Issue date
. The southern bell bonds were issued in 1977, wheninterest rates were higher than they are today.6. This southern bell bond has
physical coupons
. It started with 60,because it was a 30-year bond with semiannual payments. It now hasonly 16 coupons remaining, because the bond matures in 8 more years.7.
Default risk
is inherent in all bonds except treasury bonds--will theissuer have the cash to make the promised payments? Bonds arerated from AAA to D, and the lower the rating the riskier the bond, thehigher its default risk premium, and, consequently, the higher itsrequired rate of return, r 
s
. Southern bell is rated AAA.8.
Special features
, such as convertibility and zero coupons will bediscussed later.
Question 2
 A call provision is a provision in a bond contract that gives the issuingcorporation the right to redeem the bonds under specified terms prior to the
 
ABMF4024 BUSINESS FINANCETutorial 4 Answer November 1, 2010
normal maturity date. The call provision generally states that the companymust pay the bondholders an amount greater than the par value if they arecalled. The additional sum, which is called a call premium, is typically setequal to one year¶s interest if the bonds are called during the first year, andthe premium declines at a constant rate of INT/n each year thereafter. A sinking fund provision is a provision in a bond contract that requires theissuer to retire a portion of the bond issue each year. A sinking fund provisionfacilitates the orderly retirement of the bond issue.The call privilege is valuable to the firm but potentially detrimental to theinvestor, especially if the bonds were issued in a period when interest rateswere cyclically high. Therefore, bonds with a call provision are riskier thanthose without a call provision. Accordingly, the interest rate on a new issue of callable bonds will exceed that on a new issue of non-callable bonds. Although sinking funds are designed to protect bondholders by ensuring thatan issue is retired in an orderly fashion, it must be recognized that sinkingfunds will at times work to the detriment of bondholders. On balance,however, bonds that provide for a sinking fund are regarded as being safer than those without such a provision, so at the time they are issued sinkingfund bonds have lower coupon rates than otherwise similar bonds withoutsinking funds.
Question 3
 
H
ow is the value of any asset whose value is based on expected future cashflows determined?0 1 2 3 n| | | |
yyy
|CF
1
CF
2
CF
3
cf 
n
 PVPVThe value of an asset is merely the present value of its expected future cashflows:VALUE = PV =
§
!
!
n
CF CF CF CF 
1nn332211
)1(r)(1 CF ...)1()1()1(
.If the cash flows have widely varying risk, or if the yield curve is not horizontal,which signifies that interest rates are expected to change over the life of thecash flows, it would be logical for each period¶s cash flow to have a differentdiscount rate.
H
owever, it is very difficult to make such adjustments; hence itis common practice to use a single discount rate for all cash flows.The discount rate is the opportunity cost of capital; that is, it is the rateof return that could be obtained on alternative investments of similar risk.
 
ABMF4024 BUSINESS FINANCETutorial 4 Answer November 1, 2010
Thus, the discount rate depends primarily on factors discussed back inchapter 5:
i
= r* + IP + LP + MRP + DRP.
 Question 4
 
 A bond has a specific cash flow pattern consisting of a stream of constantinterest payments plus the return of par at maturity. The annual couponpayment is the cash flow: pmt = (coupon rate)
v
(par value) = 0.1($1,000) =$100.For a 10-year, 10 percent annual coupon bond, the bond¶s value is found asfollows:0 1 2 3 9 10| | | |
yyy
| |100 100 100 100 100 + 1,00090.9182.64...38.55385.541,000.00Expressed as an equation, we have:
$
1,000.
$
385.54
$
38.55...91.90
$
)1(000,1
$
r)(1
$
100 ...)1(100
$
10101
!! !
 B
 Or: V
B
= $100(PVIFA
10%, 10
) + $1,000(PVIF
10%, 10
).The bond consists of a 10-year, 10% annuity of $100 per year plus a $1,000lump sum payment at t = 10:PV annuity = $ 614.46PV maturity value= 385.54Value of bond = $1,000.00The mathematics of bond valuation is programmed into financial calculatorsthat do the operation in one step, so the easy way to solve bond valuationproblems is with a financial calculator.Input n = 10, k
d
= i = 10, pmt = 100, and fv = 1000, and then press pv to findthe bond¶s value, $1,000. Then change n from 10 to 1 and press pv to get thevalue of the 1-year bond, which is also $1,000.
10%

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