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Chapter 6 Gitman

Chapter 6 Gitman

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Chapter 6

Interest Rates and Bond Valuation

Solutions to Problems
P6-1. LG 1: Interest Rate Fundamentals: The Real Rate of Return Basic Real rate of return = 5.5% – 2.0% = 3.5% P6-2. LG 1: Real Rate of Interest Intermediate (a) Supply and Demand Curve
Current Suppliers

Interest Rate Required Demanders/ Supplier (%)

9 8 7 6 5 4 3 2 1 0 1 5 10 20 50 100

Demanders after new Current demanders

Amount of Funds Supplied/Demanded ($) billion

(b) The real rate of interest creates an equilibrium between the supply of savings and the demand for funds, which is shown on the graph as the intersection of lines for current suppliers and current demanders. K0 = 4% (c) See graph. (d) A change in the tax law causes an upward shift in the demand curve, causing the equilibrium point between the supply curve and the demand curve (the real rate of interest) to rise from ko = 4% to k0 = 6% (intersection of lines for current suppliers and demanders after new law).

(e) The real rate of return is 9% – 5% = 4%. Treasury issues. RP = 0 RF = k* + IP 20 year bond: 3 month bill: 1 year note: 5 year bond: RF = 2.S.0381). reflecting lower expected future rates of interest.S.5 + 6% = 8.Chapter 6 Interest Rates and Bond Valuation 145 P6-3.05) = $26.1524 ÷ 4 = 0. The curve may reflect a general expectation for an economic recovery due to inflation coming under control and a stimulating impact on the economy from the lower rates.8% more shirts (4.5% RF = 2. LG 1: Yield Curve Intermediate (a) Yield Curve of U.5% RF = 2.5% RF = 2.5 + 9% = 11. (a) (b) (c) (d) P6-4. LG 1: Real and Nominal Rates of Interest Intermediate 4 shirts $100 + ($100 × 0.5 + 5% = 7. LG 1: Nominal Interest Rates and Yield Curves Challenge (a) kl = k* + IP + RP1 For U.5 + 8% = 10. The change in the number of shirts that can be purchased is determined by the real rate of return since the portion of the nominal return for expected inflation (5%) is available just to maintain the ability to purchase the same number of shirts.1524.5% .25 The number of polo shirts in one year = $109 ÷ $26.09) = $109 $25 + ($25 × 0.25 = 4. Treasury Securities 14 12 10 8 Yield % 6 4 2 0 0 5 10 15 20 Time to Maturity (years) (b) The yield curve is slightly downward sloping. He can buy 3. P6-5.

0% 8. LG 1: Nominal and Real Rates and Yield Curves Challenge Real rate of interest (k*): ki = k* + IP + RP RP = 0 for Treasury issues k* = ki – IP (a) Security A B C D E Nominal Rate (kj) 12.0%.1% . The dashed line in the part (c) graph shows what the curve would look like without the existence of liquidity preference.0% 11.2% 13.4% – – – – – – IP 9.5% 8. the nominal interest rate in each case would decrease by 0.0% 3. ignoring the other yield curve theories.2% 10. reflecting the prevailing expectation of higher future inflation rates.1% 3. (c) Return versus Maturity 14 12 10 8 Rate of Return % 6 4 2 0 0.146 Part 2 Important Financial Concepts (b) If the real rate of interest (k*) drops to 2.9% 3.S. (e) Market segmentation theorists would argue that the upward slope is due to the fact that under current economic conditions there is greater demand for long-term loans for items such as real estate than for short-term loans such as seasonal needs.5 percentage point.0% 2. (d) Followers of the liquidity preference theory would state that the upward sloping shape of the curve is due to the desire by lenders to lend short-term and the desire by business to borrow long term.25 1 5 10 20 Years to Maturity The yield curve for U.3% = = = = = = Real Rate of Interest (k*) 3.0% 11. P6-6.6% 11.1% 8. Treasury issues is upward sloping.

The curve may reflect a general expectation for an economic recovery due to inflation coming under control and a stimulating impact on the economy from the lower rates. a federal government budget deficit. and finally increased in December. Forces which may be responsible for a change in the real rate of interest include changing economic conditions such as the international trade balance.Chapter 6 Interest Rates and Bond Valuation 147 (b) The real rate of interest decreased from January to March. remained stable from March through August.S. Treasury Securities 14 12 10 Yield % 8 6 4 2 0 0 5 10 15 20 Time to Maturity (years) (d) The yield curve is slightly downward sloping. (c) Yield Curve of U. LG 1: Term Structure of Interest Rates Intermediate (a) Yield Curve of High-Quality Corporate Bonds 15 14 Today 13 12 Yield % 11 10 9 8 7 0 2 years ago 5 years ago 5 10 15 20 25 30 35 Time to Maturity (years) . reflecting lower expected future rates of interest. or changes in tax legislation. P6-7.

5% = 6% (c) ki = k* + IP + RP or k1 = RF + Risk premium Security A: k1 = 11% + 3% = 14% Security B: k1 = 9% + 6% = 15% . reflecting lower expected interest rates due to a decline in the expected level of inflation. P6-8. it is probable that the maturity of each security differs. reflecting expectations of stable interest rates and stable inflation. Two years ago. the yield curve was downward sloping. k* 3% 3% 3% 3% 3% + + + + + + IP 6% 9% 8% 5% 11% + + + + + + RP 3% 2% 2% 4% 1% = = = = = = k 12% 14% 13% 12% 15% LG 1: Risk Premiums Intermediate (a) RFt = k* + IPt Security A: RF3 = 2% + 9% = 11% Security B: RF15 = 2% + 7% = 9% (b) Risk premium: RP = default risk + interest rate risk + liquidity risk + other risk Security A: RP = 1% + 0. Today.148 Part 2 Important Financial Concepts (b) and (c) Five years ago. the yield curve is upward sloping. the yield curve was relatively flat.5% + 1% + 1. LG 1: Risk-Free Rate and Risk Premiums Basic (a) Risk-free rate: RF = k* + IP Security A B C D E K* 3% 3% 3% 3% 3% + + + + + + IP 6% 9% 8% 5% 11% = = = = = = RF 9% 12% 11% 8% 14% (b) Since the expected inflation rates differ.5% + 1% + 0. reflecting higher expected inflation and higher future rates of interest.5% = 3% Security B: RP = 2% + 1. (c) Nominal rate: k = k* + IP + RP Security A B C D E P6-9.

29%. P6-12.06) (1 + 0. 200 $6.200 × 0.200 $5.500 bonds = $175. .06) (1 + 0. LG 4: Valuation Fundamentals Basic (a) Cash Flows: CF1–5 $1. Treasury bond is 129 basic points. This yield represents the expected compounded rate of return the investor would earn if the bond is purchased at the price quoted and the bond is held until the maturity date.789.06)5 V0 = $8.200 × 0. (CF5 × PVIF6%.06) (1 + 0.750 P6-11.008 + $950.747)] V0 = $1.791.840) + ($1. 200 $1.60 + $1.807.07) = $70. LG 4: Bond Quotation Basic (a) (b) (c) (d) (e) (f) Tuesday.068. P6-10. LG 2: Bond Interest Payments Before and After Taxes Intermediate (a) Yearly interest = ($1.000 × 0.97708 × $1. (g) The spread of this FM bond over a similar time to maturity U.l) + (CF2 × PVIF6%.000 5. November 7 0.000) 61.06%. you would be receiving less than your required 6% return.250 Net after-tax interest expense $113. or 1.Chapter 6 Interest Rates and Bond Valuation 149 Security A has a higher risk-free rate of return than Security B due to expectations of higher nearterm inflation rates.5)] V0 = [($1.631.00 + $1. The issue characteristics of Security A in comparison to Security B indicate that Security A is less risky.08 May 15. 200 $1.7% last yield = 6.40 V0 = $8.200 × 0. 2) . .200 × 0. 2013 $47.789.890) + ($1.06) (1 + 0. 200 $1.000 = $977.000 CF5 Required return: 6% CF1 CF 2 CF 3 CF 4 CF 5 + + + + (b) V0 = 1 2 3 4 (1 + k) (1 + k) (1 + k) (1 + k) (1 + k)5 V0 = $1.00 (b) Total interest expense = $70.943) + ($1.200 × 0.792) + ($6.000 (c) Total before tax interest $175.00 per bond × 2.S.35 × $175.40 Calculator solution: $8. 200 + + + + 1 2 3 4 (1 + 0.791 Using PVIF formula: V0 = [(CF1 × PVIF6%.40 + $4.000 Interest expense tax savings (0.13 The maximum price you should be willing to pay for the car is $8. . since if you paid more than that amount.131.

50 $9.00 $16.00 3.00 $14.112.n Present Value of Cash Flow 2.000 1 ÷ 0.507 Calculator solution: $16. LG 4: Asset Valuation and Risk Intermediate (a) 10% Low Risk PVIFA PV of CF 15% Average Risk PVIFA PV of CF 22% High Risk PVIFA PV of CF CF1–4 CF5 $3.076.550 $13.000 5.675 0.717.000 4.877 0.510 9.519 0.000 $1.754.592 0.407.000 15.000 1.170 0.497 $8.00 $9.871.00 Calculator solution: $10.022.00 2.500 0.663.565 7.476 Calculator solution: 3.315 $18.000 3.020 $16.52 $1.855 0.000 3.370 $7.375.769 0.500 8.15 B C 1–∞ 1 2 3 4 5 1–5 6 $300 0 0 0 0 $35.000 7.713.456 Calculator solution: P6-14.42 2.150 Part 2 Important Financial Concepts P6-13.455 $16.032 $13.00 456.36 $2.494 0.00 4.115.27 D E 1 2 3 4 5 6 $2.482 5.030.309.96 $5.00 2.00 $14.621 $9.144.50 4.91 Present Value of CF: Calculator solutions: . LG 4: Valuation of Assets Basic Asset A End of Year 1 2 3 Amount $5000 $5000 $5000 PVIF or PVIFAk%.000 0.605 0.660.59 2.307.174 $10.825 $18.823.870.

851) + $1. Laura would use the most conservative price.88 Calculator solution: $1.149. In contrast to (a) above. P6-15.89 Bo = $120 × (6.000 × (0.000 × (0.799) + $100 × (0.n) + M × (PVIFkd%.88 + $163 Bo = $999.39 $1.60 $450. therefore assuming the highest risk.032. there may have been a shift in the supplydemand relationship for money or a change in the risk of the firm.66 Bo = $80 × (8.974) + $1.149.116) = $85.00 Bo = $10 × (4.000 × (0. P6-16.47 (b) Since Complex Systems’ bonds were issued.104) = $1.88 + $218 Bo = $1.000 × (0.123. (c) Bo = I × (PVIFAkd%. LG 5: Basic Bond Valuation Intermediate (a) Bo = I × (PVIFAkd%. the bond will sell at a premium (its value will be greater than par).000.88 Calculator solution: $1.16) + M × (PVIF12%.145) + $1.376) Bo = $80 × (4.156. Unable to assess the risk.000 When the required return is equal to the coupon rate.80 $1.386) = $1. (c) By increasing the risk of receiving cash flow from an asset.Chapter 6 Interest Rates and Bond Valuation 151 (b) The maximum price Laura should pay is $13. LG 5: Bond Valuation–Annual Interest Basic Bo = I × (PVIFAkd%. which reduces the value of the asset.00 $85. the bond value is equal to the par value.n) Bond Table Values Calculator Solution A B C D E Bo = $140 × (7.000 × (0.122.000.218) Bo = $938. the required rate of return increases.16) + M × (PVIF10%.910) + $500 × (0.40 .824) + $1.90 $1. if the required return is less than the coupon rate.16) Bo = $120 × (7.n) Bo = 120 × (PVIFA12%.n) Bo = 120 × (PVIFA10%.163) Bo = $836.292) = $1.n) + M × (PVIFkd%.59 = $450.156.n) + M × (PVIFkd%.469) + $1.16) Bo = $120 × (6.

00 Bo = $110 × (5.492) + $1.18 $1.000 × (0.n) (a) Bond Table Values (1) (2) (3) (b) Bond Value versus Required Return 1.000 × (0.000. .n) + M × (PVIFkd%.536) + $1.08 1.225.286) = $1.152 Part 2 Important Financial Concepts P6-17. (d) The required return on the bond is likely to differ from the coupon interest rate because either (1) economic conditions have changed. the market value is less than the par value.187) = $783. the bond therefore sells at a discount. LG 5: Bond Value and Changing Required Returns Intermediate Bo = I × (PVIFAkd%.100 1.421) + $1. causing a shift in the basic cost of long-term funds.000 × (0.000.300 Calculator Solution Bo = $110 × (6.00 $783.200 1. or (2) the firm’s risk has changed.31 Bo = $110 × (7.000 Bond Value ($) 900 800 700 8% 9% 10% 11% 12% 13% 14% 15% Required Return (%) (c) When the required return is less than the coupon rate. When the required return is greater than the coupon rate.96 $1.397) = $1.226. the market value is greater than the par value and the bond sells at a premium.

660) + $1.877) + $1.681) = $1.57 $982.519) = $896.120.593) = $1.n) + M × (PVIFkd%. P6-19.000 × (0.140) = $877.00 B0 = $110 × (3.142) + $1.877) = $982.000 × (0.16 $886.696) + $1.79 $901. LG 5: Bond Value and Time–Constant Required Returns Intermediate Bo = I × (PVIFAkd%.n) (a) Bond Table Values (1) (2) (3) (4) (5) (6) (b) Bond Value versus Years to Maturity 1020 1000 1000 982 954 Calculator Solution Bo = $120 × (6.23 B0 = $110 × (3.308) = $901.889) + $1.208) = $887.24 $877.456) = $922.n) (a) Bond Table Values (1) (2) (3) B0 = $110 × (3.Chapter 6 Interest Rates and Bond Valuation 153 P6-18.119.433) + $1.01 .20 Bo = $120 × (4.000 × (0.000 × (0.78 $1.000 × (0.000.00 $897.000 × (0.52 Bo = $120 × (3.63 Calculator Solution $1.000 × (0.000.23 $953.000 × (0.64 Bo = $120 × (0.946) + $1.46 Bond Value ($) 980 960 940 920 900 880 860 0 922 901 887 877 2 4 6 8 10 12 14 16 Years to Maturity (c) The bond value approaches the par value.n) + M × (PVIFkd%.04 Bo = $120 × (5.07 $922.675) = $953. LG 5: Bond Value and Time–Changing Required Returns Challenge Bo = I × (PVIFAkd%.993) + $1.322) + $1.68 Bo = $120 × (2.000 × (0.

00 896. LG 6: Yield to Maturity Basic Bond A is selling at a discount to par.23 1. the more responsive the market value of the bond to changing required returns. Bond C is selling at a premium to par.000. (b) The market value of the bond approaches its par value as the time to maturity declines.000 × (0.142) + $1.60 1.000. she would choose Bond A with the shorter maturity. P6-20.28 Since Bo is $955.000 × (0.000 × (0. Bond E is selling at a premium to par.15) + 1.569) + $1.73 Value Required Return Bond A Bond B 8% 11% 14% $1. This proof is as follows: Bo = 120 × (PVIFA12. Bond B is selling at par value.685%. and vice versa.256. LG 6: Yield to Maturity Intermediate (a) Using a financial calculator the YTM is 12. (d) If Lynn wants to minimize interest rate risk in the future.000 × (0. The correctness of this number is proven by putting the YTM in the bond valuation model.63 $1. .000 × (PVIF12.62 The greater the length of time to maturity. the YTM is equal to the rate derived on the financial calculator.154 Part 2 Important Financial Concepts (b) Bond Table Values Calculator Solution (1) (2) (3) (c) B0 = $110 × (8.256.256.62 $1. The yield to maturity approaches the coupon interest rate as the time to maturity declines.191) + $1.560) + $1. Any change in interest rates will impact the market value of Bond A less than if she held Bond B.28 + 167 Bo = $955.209) = $1.685%.120.000.167) Bo = $788.00 B0 = $110 × (6. P6-21.00 815.00 $815.140) = $815.685%.60 B0 = $110 × (7.315) = $1.000.28 and the market value of the bond is $955.15) Bo = $120 × (6.78 $1. Bond D is selling at a discount to par.

6: Bond Valuation and Yield to Maturity Challenge (a) BA = $60(PVIFA12%.35 0.15 10.95% (b) The market value of the bond approaches its par value as the time to maturity declines.5) BA = $60(3.017 8. The yield-to-maturity approaches the coupon interest rate as the time to maturity declines.30 BB = $140(PVIFA12%. LG 2. 5. 000 + $1.5) + $1. 000 + $900) ÷ 2] 12.5) BB = $140(3.02% E = $50 + [($1.000(0.22% = 13.000(PVIF12%.00% = 12.5) + $1.605) + $1.71% 12.Chapter 6 Interest Rates and Bond Valuation 155 P6-22.70 .071.567) BA = $216.605) + $1.81% = 8.22% +0. P6-23.77% 8.120 ÷ 2] 10.38% D = $150 + [($1.00% –0.71% 12. 000 − $900) ÷ 3] [($1.000 − $820) ÷ 8] [($1.30 + 567 BA = $783.81% +0. 000 − $120) ÷ 10] [($1.000 + $820) ÷ 2] 12.000(0.00% = $60 + [($500 − $560) ÷ 12] [($500 + $560) ÷ 2] = 10.70 + 567 BB = $1.000(PVIF12%.21 12.94% –0. LG 6: Yield to Maturity Intermediate (a) Bond Approximate YTM Trial-and-Error YTM Approach Error (%) Calculator Solution A = $90 + [($1.36% B C = 12.567) BB = $504.00 12.

15 P6-25. the yield to maturity of bond A is 11.247) + $1.612.11 .462) + $1.854.34 $1.72 = $76.67 (d) At the end of the 5 years both bonds mature and will sell for par of $1.156 Part 2 Important Financial Concepts (b) Number of bonds = $20.531.024) + $500 × (0.533 bonds × $60 = $1.000 FVB = $140(6.n) Bo = $50 × (PVIFA7%.30 $20.071.00 Bo = $30 × (7.5) + $1.533 of bond A $783. The principal payments at maturity will be the same for both bonds.105) + $1.15 + $444 Bo = $841.000 × (0.n) + M × (PVIFkd%.249.12) Bo = $50 × (7.77% and the yield to maturity of bond B is 11.152.30 + $1.35 Bo = $60 × (15.n) Bond Table Values Calculator Solution A B C D E Bo = $50 × (15.15 Calculator solution: $841.105) + $1.152.00 $464.000 = $1.582) = $464.66194 bonds × $140 = $2.097) = $1.70 (e) The difference is due to the differences in interest payments received each year.000 × (0. Using the calculator. P6-24.390) = $1.5) + $1.377) = $1.508) Bo = $3 × (5. The reasoning behind this result is that for both bonds the principal is priced to yield the YTM of 12%.943) + $1.971) + $100 × (0.366.70 (c) Interest income of A = 25.30 FVB = $140(FVIFA10%.000 × (0. Mark would be better off investing in bond A.000 FVB = $854.47 $1.88 $1.662 of bond B $1. LG 6: Bond Valuation–Semiannual Interest Intermediate Bo = I × (PVIFAkd%.70 + $1.11 Bo = $70 × (12.249.444) Bo = $397.24 $76. bond B is more dependent upon the reinvestment of the large coupon payment at the YTM to earn the 12% than is the lower coupon payment of A. FVA = $60(FVIFA10%. However.12) + M × (PVIF7%.000 FVA = $366.000 Number of bonds = = 18.000.000.000 = 25. LG 6: Bond Valuation–Semiannual Interest Intermediate Bo = I × (PVIFAkd%.n) + M × (PVIFkd%.000.046) + $1.98 Interest income of B = 18.59% with the 10% reinvestment rate for the interest payments.000 FVA = $60(6.000 = $1.000 × (0.

in order to get the most accurate data and rating methods possible.n) + M × (PVIFkd%.889. and unbiased reading on a company’s bond issues’ creditworthiness? Rating agencies should be expected to invest heavily in statistical models and management meetings. .424. are investors being provided an accurate.Chapter 6 Interest Rates and Bond Valuation 157 P6-26.422. The primary ethical issue is.000 × (0. they cast raters in an even worse light.38 + $1.40) + $5. Ethics Problem Intermediate Absolutely not—if anything.000 × (PVIF3%. The fact they have done all this and still not carried out their responsibility to investors at a high degree of proficiency is concerning.n) Bo = $125 × (PVIFA3%.115) + $5.13 P6-27.40) Bo = $125 × (23. LG 6: Bond Valuation–Quarterly Interest Challenge Bo = I × (PVIFAkd%.307) Bo = $2. timely.535 Bo = $4.38 Calculator solution: $4.

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