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Business-Finance Tutorial 4 Cont Answer

Business-Finance Tutorial 4 Cont Answer

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Published by: Chia Kong Haw on Dec 23, 2010
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ABMF4024 BUSINESS FINANCE Tutorial 4 Cont’ AnswerNovember 1, 2010
Question 1
The current yield will be equal to the yield to maturity when the current price of the bond is equal to its par, or maturity, value. In this case there will be no capital gain (or loss) when the bond matures.
Question 2
The
 yield-to-maturity
is the rate of return expected to be earned if a bond is purchasedat a given price and held until maturity. The
coupon
or 
current yield 
is equal to theannual interest payment divided by the current price. Yield-to-maturity takes intoaccount interest returns as well as any capital gains (or losses) over the remaining lifeof the bond. The coupon or current yield considers only the interest returns andignores any capital gains (or losses).
Question 3
a)Bond will sell at a
discount 
if the required rate of return is
 greater than
thecoupon rate. b)A bond will sell at
 par value
if the required rate of return is
equal 
to thecoupon rate.c)A bond will sell at a
 premium
if the required rate of return is
less than
thecoupon rate.
Question 4
A bond is classified as a fixed income security because the holder expects to receiveconstant interest payments each period. If the bond is held until maturity, the realizedrate of return is independent of fluctuations over time in the market price of the bond.
Question 5
If a company sold bonds when interest rates were relatively high and the issue is callable,then the company could sell a new issue of low-yielding securities if and when interestrates drop. The proceeds of the new issue would be used to retire the high-rate issue, andthus reduce its interest expense. The call privilege is valuable to the firm but detrimentalto long-term investors, who will be forced to reinvest the amount they receive at the newand lower rates.
Question 6
The rate of return is approximately 15.03%, found with a calculator using the followinginputs: N = 6; PV = -1000; PMT = 140; FV = 1090; I/YR = ? Solve for I/YR = 15.03%.Despite a 15% return on the bonds, investors are not likely to be happy that they werecalled. Because if the bonds have been called, this indicates that interest rates have fallensufficiently that the YTC is less than the YTM. (Since they were originally sold at par, theYTM at issuance= 14 %.) Rates are sufficiently low to justify the call. Now investorsmust reinvest their funds in a much lower interest rate environment.

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