Valerie Jean G.

Bilbao Aaron Gonzales MWF 6:30-7:30

11/25/2019

A. What are a bond’s key features?

 Par Value - is the stated face value of the bond or the amount of
money a firm obtains and promises to reimburse on maturity date
 Maturity Date - a specific date where the par value of the bonds must
be reimbursed
 Coupon or Interest Rate - is the amount of interest payment that must
be made
 Issue date - the date the bonds were issued.

B. What are call provisions and sinking fund provisions? Do these

provisions make bonds more or less risky?
Call provisions is an arrangement in a bond contract that gives the issuer
the privilege to reclaim the bonds before the stated maturity date. If the
provision was applied, the company must pay the bondholders an amount
greater than the par value called the premium (one year interest). It is
important to the company but it may be dangerous to the investors. On the
other hand, the sinking fund provision requires the issuer to retire a portion of
the issued bond annually. Bonds with call provisions are riskier than the
bonds without such provision meanwhile bonds with sinking fund provision is
safer than those without this provision.

C.How is the value of any assets whose value is based on expected

future cash flows determined?
The value of any asset is is deteremined by the present value of its
expected future cash flows:

n
=  CFt t .
CF1 CF2 CFn
PV = + .. +
(1 + r )1 (1 + r )2 (1 + r )n t = 1 (1 + r )

D. How is the value of a bond determined? What is the value of a 10-

year, $1,000 par value bond with a 10 percent annual coupon if its
required rate of return is 10 percent?
The value of the bond can be determined by finding the present value of
the cash flows of the bond and this includes the annual coupon payment and
the face value.

The value of a 10 year, 10% annual coupon bond with a 10% required rate of
return is as follows:

PV of One = (1+10%)-10 → 0.386

PV of Annuity = 1 - (1 +10%)-10 → 6. 145
10%

Principal = 1,000 x 0.386 = 386

Interest = 100 x 6.145 = 614.50
$1,000
E. 1. What is the value of a 13% coupon bond that is otherwise identical
to the bond described in part D? Would we now have a discount or a
premium bond?
PV of One = (1+13%)-10 → 0.295
PV of Annuity = 1 - (1 +13%)-10 →5.426
13%

Principal = 1,000 x 0.295 = 295

Interest = 100x 5.426 = 542.62
$ 837.62

In a situation like this, where the required rate of return rises above the coupon rate, the
bonds' values fall below par, so they sell at a DISCOUNT.

2. What is the value of a 7% coupon bond with these characteristics?

Would we now have a discount or premium bond?
PV of One = (1+7%)-10 → 0.508
PV of Annuity = 1 - (1 +7%)-10 → 7.024
7%

Principal = 1,000 x 0.508 = 508

Interest = 100x 7.024 = 702.4
$ 1,210.4

When the required rate of return falls below the coupon rate, the bonds' value rises above
par, or to a PREMIUM.

3.What would happen to the values of the 7%, 10%, and 13%
coupon bonds over time if the required return remained at 10%?
As the bonds reaches near its maturity date, the value of the
bonds are increasing in the case of discount bound and in the case of the
premium bond, its value is decreasing so that at the maturity date, the
amount of will be equivalent to its face or par value when it was
received.

F. 1. What is the yield to maturity on a 10 year, 9% annual coupon,

$1,000 par value bond that sells for $887.00? That sells for $1,134.20?
What does the fac that it sells at a discount or at a premium tell you
about the relationship between rd and the coupon rate?
A. Step 1: Market Price = 887 (9%)
* If 11% is used: PV of One = (1+11%)-10 → 0.352 x 1,000 = 352
PV of Annuity = 1 - (1 +11%)-10 → 5.890 x 90 = 530.10
11% 882.10

Step 2: 9% = 1, 000 (1,000 - 887 = 113)

11% = 882.10
117.90

→ 9% + 113 x 2% = 10.92% YTM of the bond that sells for

117.90 $887
 B. Step 1: Market Price = 113.20 (9%)
* If 7% is used: PV of One = (1+7%)-10 → 0.508 x 1,000 = 508
PV of Annuity = 1 - (1 +7%)-10 → 7.024 x 90 = 632.16
7% 1,140.16

Step 2: 7% = 1,140.16 (1,000 - 1,140.16 = 140.16)

9% = 1, 134.20
5.96

→ 7% + 5.96 x 2% = 7.08% YTM of the bond that sells for

140.16 $1,134.20

C. When the required rate of return exceeds the coupon rate, the
bond will sell at a discount however, if the coupon rate is greater
than the required rate of return the bond will sell at a premium.

2. What are the total return, the current yield, and the capital gains
yield for the discount bond? Assume that it is held to maturity,
and the company does not default on it.

Total Return = Current Yield + Capital Gains Yield

= 10.15% + 0. 77%
= 11.27 %

Current Yield = Annual Interest / Bond Price

= 90 / 887
= 10.15%

Capital Gains Yield = YTM - Current Yield

= 10.92% - 10.15%
= 0. 77%

G. What is price risk? Which has more price risk, an annual payment 1
year bond or a 10 year bond? Why?
Price or interest rate risk is the possibility where the bond loses its value
because of an increse in the interest rates. A 10 year bond has more price
risk since as time goes by, interest rates fluctuates does the longer the
maturity date, the lesser will be the worth of the bond.

H. What is reinvestment risk? Which has more reinvestment risk, a 1

year bond or a 10 year bond?
Reinvestment rate risk is a probability where the income portfolio of the
bond will decline as a result of the decrease in interest rates. Both the short
term and the long term bonds has reinvestment risk however, this risk is more
significant in the 1 year bond because as soon as the bond matures, there is
a possibility that the investor will roll it over every year and if the rates
decreases, the income that will be received will also decline.
I. How does the equation for valuing a bond change if semiannual
payments are made? Find the value of a 10 year, semiannual payment,
10% coupon bond if normal rd= 13%
If the bond payments are made semiannually, we use the same
formula however the following changes are applied:

Maturity Date (n) = Multiplied by 2

Required Rate of Return = Divided by 2
Coupon Rate = Divided by 2

The value of the 10 year, 10% coupon bond with the ROR of 13%
semiannual payment is computed as follows:
N = 20 years ROR= 6.5% Coupon Rate= 5% Face Value=
1,000

PV of One = (1+6.5%)-20 → 0.284

PV of Annuity = 1 - (1 +6.5%)-20 → 11.019
6.5%

Principal = 1,000 x 0.284 = 284

Interest = 50x 11.019 = 550.95
$ 834.95 BOND VALUE

J. Suppose for $1,000 you could buy a 10%, 10 year annual payment
bond or a 10%, 10 year, semiannual payment bond. They are equally
risky. Which would you prefer? If the $1,000 is the proper price for the
semiannual bond, what is the equilibrium price for the annual payment
bond?
m
 I 
EAR =  1 +  -1
 m 
2
 10% 
=  1+  -1
 2 

= 10. 25% EAR of Semiannual payment Bond

The semiannual payment bond is preferred since it has a higher return

than the annual payment bond

Equilibrium price for the annual payment bond is computed as follows:

PV of One = (1+10.25%)-10 → 0.377
PV of Annuity = 1 - (1 +10.25%)-10 → 6. 079
10.25%

Principal = 1,000 x 0.377 = 377

Interest = 100x 6.079 = 607.90
$ 984.90
K. Suppose a 10-year, 10 percent, semiannual coupon bond with a par
value of $1,000 is currently selling for $1,135.90, producing a nominal
yield to maturity of 8%. However, it can be called after 4 years for a
price of $1,050.
1. What is the bond’s nominal yield to call (YTC)
$1,135.90 = 50 (1-( 1+X)-8 + 1,050 (1+X) -8
X
X = 3.57
X= 7.14% YTC

2.If you bought this bond, would you be more likely to earn the
YTM or the YTC? Why?
Given that the coupon rate which is 10% exceeds the YTC which
is 7.14%, the company could call the old bonds, which pay $100 every
year, and replace them with bonds with the annual interest payment of
$71.40 so it could save at least $29 per outstanding bond. Therefore,
the bond will probably be called if the interest rate remains at such
level. The investors would more likely to earn the Yield to Call.

L. Does the yield to maturity represent the promised or expected return

on the bond? Explain.
The yield to maturity is the amount of return that the investors
would acquire if all the promised payments are made. The yield to
maturity can also be perceive as the promised or expected return on
the bond. The yield to maturity (YTM) can only be the same with the
expected return when there is no default that took place and the
bonds cannot be called. Bonds with default risk or which was called
has the probability that the YTM will not be the same from the
expected return.

M. These bonds were rated AA- by S&P. Would you consider them
investment grade or junk bonds?
The AA- (Double A) bonds would be considered as an investment
grade bonds along with triple A, double A, and triple B bonds. However,
bonds that was rated as BB (Double B) and lower are considered as junk
bonds.

N. What factors determine a company’s bond rating?

Bond ratings are based on both qualitative and quantitative factor
some of which are:
 1. Financial Ratios

2. Bond Contract Terms (Maturity, Coupon Rate, Secured or

Unsecured Bond, Sinking fund provisions, With guarantee or
Not)

3. Firm’s Earning

4. Potential Environmental Problems

5. Potential Antitrust Problems

N. If this firm were to default on the bonds, would the company be

immediately liquidated? Would the bondholders be assured of receiving
all their promised payements? Explain.
The decision whether to liquidate the company or not depends if
the worth of the reorganized firm is greater than the amount of the
assets of the company if it were to be sold separately. If the
company is deemed to be more “dead” than “alive” then liquidation
will take place otherwise, a reorganization should be considered. In
reorganization, a restructuring of debt might take place that may
result to the reduction of interest rate, longer maturity date, or equity
will be exchanged to pay off some portion of debt which will allow
the entity to comply with its obligation.

Whether the company was liquidated or reorganized, the

bondholders will not receive all their promised payments since the
amount of proceeds from the liquidation are not sufficient to pay the
bondholders. Seniors debt are paid first then the settlemet for junior
debt follows.