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CASE INFORMATION Purpose This case is designed to review bond and stock valuation concepts. It is designed to illustrate the mechanics of valuation and to familiarize students with standard reporting formats of basic financial data. The case illustrates the impact of inputs into the valuation process. Time Required Without using the model, 6-8 hours of student preparation should be adequate for most students. An additional hour or so is needed to write up the case if required. Use of the spreadsheet model can reduce preparation time, especially if the completed model or the easy macro version is given to the students. Complexity B--Intermediate complexity. Much of the initial valuation is relatively straight forward, but it requires a fair amount of number crunching for students not using the spreadsheet model. Some of the questions involving risk adjustments are more difficult, and this raises the overall complexity of the case. Ways To Use the Case This case can be used in two different ways. With the introductory and not-very-well prepared second course students, students can be asked to read the case and then to become generally familiar with it. The case can then be used in class in lieu of a lecture to ensure that students understand how to obtain pertinent information from standard financial sources and to understand the issues involved in valuation. When the case is used in this manner, assign the directed version. The questions in the directed version lead students through the topics that should be addressed, and they provide structure to the class. The case itself sets the context in which all calculations and decisions are made, and this often works better than a pure lecture because the case makes the material seem “more relevant.” This usage is particularly effective with evening students and/or executives and managers. With more advanced students, the case can be assigned to teams. One team presents their findings and conclusions to the class, and a second team acts as the CEO to respond to the initial presentation, correct errors, make clarifications, and add to the understanding of the material. This allows students to improve their listening and response skills. The other teams are asked to prepare written reports with limited page requirements plus exhibits. Students can be asked to play the role of internal or external consultants, reporting to management or shareholders. When the case is assigned in this manner, the non-directed version is recommended. With the directed version, the presentation and reports are too mechanical -students just answer the specific questions. With the non-directed version, students have more scope to consider different things, and to use different numbers in arriving at their “answers.” This makes things more interesting, and discussions among the students are more likely to arise. In either type of usage, students should read the relevant chapter(s) in a standard finance

Copyright ©1997 by The Dryden Press All rights reserved

49-1

Copyright ©1997 by The Dryden Press All rights reserved. the students should discuss how they.XLS (Excel version). the instructor should read through the case and then read through the questions and answers provided in this solution. 49-2 .WK1 (Lotus version) and Case49I. Model Use For consistency. It also calculates preferred and common stock price and return. Instructor Preparation Regardless of which version is used. The INPUT DATA and KEY OUTPUT sections of the model are shown below. MODEL INFORMATION Description The spreadsheet model for this case is saved under the filename Case49I. Other points could be made. However. as in the business world. but the questions and answers will give a good indication of how to deal with the case.) Students should be informed that in this case. as consultants. but no data is provided in the case. This sometimes forces students to think about different but relevant issues and it opens things up in terms of giving them scope for digging into the subject. They can be encouraged to make up realistic data and then analyze it within the context of the case. and they touch on most of the points that students are likely to bring up when they go through the case. There is some danger that beginning students will not really understand the basic logic underlying the model if they are not required to do some calculations by hand. they may not be provided all the data and other information they would like. but all texts cover the material in this and other cases. The questions are from the directed case. we emphasize financial calculator solutions for learning the models and the spreadsheet application for sensitivity analysis to determine how changes in the variables affect the results. If an issue is addressed in the text or chapter that seems relevant to the case. The model calculates values. (Some texts work better than others for reference purposes. would go about getting the missing data and then using it. we developed a spreadsheet model for this case.textbook. yields and EAR for semiannual payment bonds identified in the case.

INPUT/OUTPUT INPUT DATA: KEY OUTPUT: Bond and Note Analysis: Bond and Note Analysis: 8-Year Note 2003): Annual coupon rate Par value Required return Price 6.39% 8.77% 8.20 8-Year Note: Semiannual coupons: Value YTM EAR 26-Year Bond: Semiannual coupons: Value YTM EAR 28-Year Bond: Semiannual coupons: Value YTM EAR $872.024.75% $1.50% $910.000 9.38 7.25% $1.98 49-3 .50 Preferred Stock Analysis: (Series A) $ Div.00% $920.26% 8.43% 26-Year Bond (2021): Coupon rate Par value Required return Price 9.00 $43.68% $1.380% $100. Nom return EAR return $3.92 8.50% 8.00% Common Stock Analysis: Common Stock Analysis: Constant growth model: Copyright ©1997 by The Dryden Press All rights reserved Price $20.70% $1.34 Preferred Stock Analysis: (Series K) Dividend yield Par value Price 3.000 9.00% $1.96 8.50 28-Year Bond (2023): Coupon rate Par value Required return Price 7.57% $897.000 8.090.04 8.

60.36% $27.00% 4.88% 9. companies increase dividends only after management is confident that the company will be able to continue paying.00 Return 7. what was James River's price at the beginning of 1995? P0 = D1 k-g = $0. 49-4 .00% 4.56% 1.94% 8.60 Value Yield : Yr.00% 9.50% 7.50% CG Yld Tot Yld 7.50% $0. The constant growth assumption does not require that one literally expect the growth rate to be identical each year.58 Div. Note: James River’s stock dividends grew rapidly from 1978 through 1989.Next dividend (D1) Normal growth rate Required rate Price $0. All that is required is that the best current estimate of growth for any future year is the expected growth rate from the previous year. although the dividend Copyright ©1997 by The Dryden Press All rights reserved..60 5.0550 = $20. Assume that the required return for James River was 8.50% 1. or Gordon Model.36% on January 1. and the next dividend (1995) is expected to be $0. What conditions must hold to use the constant growth model? Do many "real world" stocks satisfy the constant growth assumptions? The constant growth model requires that per share dividends are expected to grow at some constant rate forever. mature companies.76% 9. Often.50%.00% 4. James River's expected annual dividend growth rate from the 91-93 to 97-99 period is 5.74% 1.0836 . the new level of dividend into the future.50% 8.00% 9. Yld 1.50% 7.50% 9. No real world stocks meet the constant growth assumptions on an ex post basis.60 . at a minimum.62% 1. but rather ex ante.67% 1. According to ValueLine estimates in figure 1. a. 1992 1993 1994 1995 1996 $34. the assumption is not unreasonable for large.00% 8. This implies that the company's earnings (and presumably its sales and assets) are also expected to grow at that same constant rate.72% Non-constant growth model: Non-constant growth rates: 1996 1997 1998 1999 Normal growth rate Required rate Next dividend (D1) 4.98 b.50% 7.50% growth rate was expected to continue indefinitely.83% 9. Based on the constant growth rate. and that the payout remains constant. 1995 and that the 5.

36% to 7. Based on this information.04) = 0.55 1997 0. b.0% for the following four years before following the normal growth model.72%.00% after that time.0% growth rate until 2000 but would increase the company's normal growth rate to a constant 8.702/(1. We find that the expected return on the stock decreased from 8.649/(1. A successful joint venture is expected to result in the 4. The Wall Street Journal (WSJ) lists the current price of James River common stock at $27. The ValueLine analysts expect the company to work through their current difficulties and increase dividends by 1997-99 to $0. the dividend yield and the capital gains yield remain constant over time. future dividends are very difficult to estimate and. The increased price of the stock indicates expectations of higher value. both dividends and price grow at the same constant rate.095)2 1998 0. Expected return = D1 / P0 + g = $0.50%.60/$27 + 5. there is much uncertainty in the entire stock valuation process.52 .50% = 7.00.80. this indicates that investors expect the company to be less risky. Dividends are expected to be $0.60 next year and grow at 4.095)3 1999 0. and the annual rate of dividend change for the growth estimate.49 .702 = 0. what is the company's return on common stock using the constant growth model? What is the expected dividend yield and expected capital gains yield? Explain the difference in the required return estimates from the ValueLine (see question 1a) to the WSJ price data.60 = 0.60(1. Year Dividend PV Dividend 1996 0.675/(1. Thus to value the stock.04) = 0. what is the value of the company's stock? The value of the stock is the present value of all expected future dividends. The joint venture also is expected to increase investors' required return to 9. and the company held the dividend at $0. a. Because the constant growth model is a reasonable long run approximation. find the expected dividends for each year during the non-constant growth period and the price when the normal growth period starts.04) = 0.was held constant in 1982. In general. and 1987. Based on this information.60/(1. 3. Then.675 4 = 0.624/(1.095) = 0.095) 2000 0. Therefore. 2.50% = 2. In 1990 the company started experiencing earnings difficulties. b. hence.624 = 0. it is often applied even when the firm does not strictly meet the assumptions. Expected capital gain yield is the expected growth at 5.649(1.095)5 Copyright ©1997 by The Dryden Press All rights reserved 49-5 .649 = 0. if dividend growth is expected to vary in a systematic way.44 .22%.72%.60 (except for 1991 when the dividend decreased).47 .675(1.50%.04) = 0. such as when dividends have been omitted or early in a firm's life. However. then the non-constant growth model should be used. Expected dividend yield = D1 / P0 = 2.22% + 5. Since the constant growth model assumes a constant growth rate in expected cash flows. 1985.600 . What is the relationship between dividend yield and capital gains yield over time under constant growth assumptions? Under constant growth. Investors’ expectations concerning either the future cash flows or the risk of the company changed between the time of the ValueLine estimates and the WSJ transaction information. Note: this corresponds to the dividend yield reported in the WSJ. sum the discounted value of each cash flow back to the present.633(1. the ValueLine 1995 expected dividend.

095)2 . After the initial dividend of $0.60 0.11 = $34. discuss the changes in dividend yields and capital gains yields over time.095)3 + (.649/(1.015 = $50.In year 2000 you also receive the price at the constant growth of 8%.624 . P2000 = D200 = $0.58 37. What is the value of the stock at the end of the first year assuming that the stock is in equilibrium? At the end of the year the stock price (value) is one year further on the time line.27 40.54 + . capital gains yield.675/(1.544)/(1. For 1996 the dividend yield = $0. 0.0800 = 0.675 $ 0.58 = 7.27.18 43.246 1999 2000 2001 Value = .82 0.$34.47 + .58 58.35 46.Pt-1) / Pt.62 0.702 =>Normal $50.49 + .0% growth rate.65 = $37.702 Normal $50.702 + 50.60/$34. and the constant growth rate starts in 2000.624/(1. the dividend yield is Dt/Pt-1.544 1995 1996 1997 1998 1999 2000 2001 /--------------/-----------/-----------/------------/------------/-----------/ .544 growth $51. 49-6 .66 68.76 c.27 .758 .51 + $35.54 54.675 $ 0.52 + . In each year t.095)+ .095)5 = $32.67 0.76 0.57 + .554/(1.624 only three more dividends will be paid at the lower 4. and the total yield is dividend yield plus capital gain yield.54 growth The present value of the price at the year 2000 = 50. and total yield of the stock for the year? If you are using the spreadsheet model for this case.55 + .60 .88 0.95 Stock Value $34.74% The capital gains yield = ($37.624 .58 = 1.78% Copyright ©1997 by The Dryden Press All rights reserved.649 .095)4 = .95 63. What is the dividend yield.11..0950 .44 + 32.70 0.649 .79 50. The expected stock price is found as follows: 1996 1997 1998 /--------------/-----------/------------/------------/-----------/--------.58 b. A listing of stock prices each year from the spreadsheet is below.702(1. (Note some differences due to rounding) End of Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 t 0 1 2 3 4 5 6 7 8 9 Div. The present value of the expected cash flow stream is $0.65 0.58)/$34.08) 1 k-g . the capital gains yield is (Pt .

78% = 9.50%. the capital gains yield equals the constant growth rate of 9.50% 9.50% 1.00% 8.60 for the next five years and then grow at a constant rate of 5.60 rather than growing at 5.50%.98 price in question 1 if the initial dividends remained constant at $0. would the stock value be higher or lower than that in part a? If you are using the spreadsheet model for the case. (Note some differences due to rounding).00% 8.50%.50% 9.50% each year.50% 1.83% 7. calculate the dividend yield.50% 1. If the required return is the original 8. The mathematics of the discounting process forces the stock price to be such that the expected return equals the required return.50% 9.50% CG Yield 7.94% 8.00% Total Yield 9.62% 1. This is because the growth rate in the constant growth phase is higher than in the initial non-constant growth phase.The total yield = 1. The value of the stock would be lower than the $20.50% 9. The lower value is the result of lower expected cash flows for the first five years.50% The dividend yield decreases each year while the capital gains yield increases each year of the non-constant growth period.00% 8.56% 1. Suppose that the dividend was expected to remain constant at $0.67% 1.36% from question 1. capital gains yield. d.74% 1. Note that in 2000 and thereafter.52% A listing of stock prices each year from the spreadsheet is listed. Copyright ©1997 by The Dryden Press All rights reserved 49-7 .50% 9. End of Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 Div.50% 9. The net affect is that the total yield remains at the required return of 9. Yield 1.50% 9.76% 7. and total yield from 1996 through 2004.88% 7.50% 1.50% 9.74% + 7.00% 8.

50% 5.35% 5.87% 5. One method of determining the company's growth rate is from the fundamentals of the retention ratio and return on retained earnings.36% 8. investors do not expect the historical beta of 1.19% 5.based on ValueLine's 1997-1999 estimated retention ratio (Hint: use 1 . Using the yields for the 10 year T-bond from the Wall Street Journal. 49-8 .36% = 2.Rf) Expected return = Rf + _ (risk premium) K = 6.40% + 1. given a constant growth rate.60 .18 The dividend yields.60 Normal $22. How does the growth rate -.36% Expected return = D1 / P0 + g = $0.60 . capital gains yields. and total yields for 1996 through 2004 are as follows: Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 Div. Growth is expected to increase in the future.5% may be understated. This implies that the inputs into the models are not consistent.2 to represent the future risk of the company.36% 8.73% return found in question 2.2 ( 6.36% 8.86% 2.20%. The estimated constant growth rate of 5.% all dividends to net profit) and expected return on retained earnings of 10. The growth rate is slightly smaller than the dividend growth forecast of 5.50% 5. what is the required return on the stock based on the CAPM? How does this return compare to the return found in question 2? Based on the CAPM: Expected return = Rf + _ (Rm .03% 5. Answer the following questions on preferred stock using the Wall Street Journal stock information.17% 3.58%.86% 2. Alternatively.86% CG Yield 4.60 / $27 + 5.36% 8. Yield 3. the stock does not provide the return required for a stock with risk 20% greater than the market.1995 1996 1997 1998 1999 2000 2001 /--------------/-----------/-----------/------------/------------/-----------/ . 6.affect the return on the stock as compared to the initial return found in question 2? g=b*r g = .60 $ 0.50% 5.5%) = 5. The analysis indicates that.36% 4. a.51 ( 10.49% 3.50% Total Yield 8.5%.01% 2.86% 2.36% 8. What is the nominal expected rate of return for James River series K preferred stock? (Hint: Copyright ©1997 by The Dryden Press All rights reserved.22% + 5.33% 3.73 Price = $17.13 growth $22.36% 8.36% 8. Thus the expected return of 7.36% 8. and the beta from ValueLine.2%) = 13. 5.50% 5.84% The required return is far greater than the expected return found in question 2.36% = 7.58% is also somewhat lower that the 7. an annual average risk premium of stock over risk free treasuries of 6.5% -.60 .86% 2.

04 26-year bond: Semiannual coupon payments = 9. Based on the required returns of 8.845.2(5) = 3 years n = 3 years (4 quarters per year)= 12 The payment each quarter = $0. The rate of return = D/P.845 Quarterly return = $0. The lower coupon for the 2003 notes may result from an upward sloping yield curve. b.7%($1.2(2) + . a.) What is the effective annual rate? Nominal Rate: Preferred stock is a perpetuity and is valued as D/kp.000)/2 = $46.38 / 4 = $0.2(3) + .76/4 = 2. resulting in a larger required return and coupon at issue.845/$43.25% Compute price = $897.25 Number of semiannual payments = 26 (2) = 52 Copyright ©1997 by The Dryden Press All rights reserved 49-9 .50 Number of semiannual payments = 8 (2) = 16 Future Value at maturity = $1. This is consistent with the WSJ dividend yield of 7.77%.76%? A sinking fund issue is no longer a perpetuity.2(4) + . If 20% of the shares are redeemed annually. Other possible explanations include the following. the probability of holding the stock each year is 20% and the expected holding period if the following Years = .000 Required semiannual return = 8. what are the values of the semiannual coupon bonds and notes held in Ms. Effective Rate: Quarterly dividend = $3.8%.94% Effective annual rate = (1.50 = 1. Future value at redemption = $100 Discount rate = 9.50. Why do the coupon rates of James River debt vary so widely? Companies generally sell bonds at par and set the coupon rate at the market rate of interest when the bonds are issued. Answer the following questions concerning James River debt using the S&P Bond Guide Information.58 7.50 = 7. Interest rates have declined over the period when the 2021 and 2023 bonds were issued. consequently coupons may have also dropped. The Wall street Journal lists the series K preferred stock annual dividend at $3.000)/2 = $33. The risk characteristics of the company may have change between issues.38 and the price at $43. Nominal return = $3.Preferred stock pays a quarterly dividend.00% b.5% and 9% for similar short term and long term bonds respectively.0194)4 -1 = 08. Investors may believe that rates will rise and therefore require a higher rate for the longer term bonds.2(1) + .44% Price = $83. The number of years is based on the expected holding period.38/$43.25%($1. Longer term bonds may include a larger term premium.50%/2 = 4. Peabody's portfolio? Are the bonds and notes selling at a discount or a premium. The valuation changes to the present value of expected future cash flows. What is the value of the preferred stock if it has a sinking fund in which 20% of initial issue of stock was redeemed annually at par ($100) and the required nominal return is 9. 8-year note: Semiannual coupon payments = 6.

8-year note: Semiannual coupon payments = 6.20 Computed semiannual rate = 4.000)/2 = $33.50% Compute price = $1. what is the nominal yield to maturity of each issue in the portfolio? What is the effective annual rate? Would you expect a semiannual payment bond to sell at a higher or lower price than an otherwise equivalent annual payment bond? Explain why.43% Copyright ©1997 by The Dryden Press All rights reserved.7%($1.024.0413)2 . The 26 year bond has a coupon above the required return and is selling above the $1.000 Required semiannual return = 9.000 par value.000 par value. it is selling at a premium.13 (2) = 8.75%($1. Therefore.50% Compute price = $872.92 The note and 28 year bond have coupons below their respective required returns and are selling below their $1.13% Nominal rate of return = 4.75 Number of semiannual payments = 28 (2) = 56 Future Value at maturity = $1. Based on the bond analysts current expected prices of the company's debt. 49-10 .Future Value at maturity = $1.50 Number of semiannual payments = 8 (2) = 16 Future value at maturity = $1.000)/2 = $38.96 28-year bond: Semiannual coupon payments = 7.00%/2= 4.000 Required semiannual return = 9. they are selling at a discount.00%/2 = 4. 8. Therefore.1 = 8.000 Present value or Price = $910.26% Effective annual rate = (1.

68% A semiannual coupon payment bond should sell at a higher price than an otherwise equivalent annual coupon payment bond. The fact that some of the coupons are received earlier and can be invested longer make semiannual coupon bonds more valuable. 9.38 Effective annual rate = (1.1 = 8.73 a.000 Price = $1.50% Effective annual rate = (1.1 = 8.25 (2) = 8.73 = 8.73 Compute semiannual rate = 4.25%($1.000 Price = $920.371.25 (2) = 8.0419)2 .42% Premium bond current yield = $120/$1.50/$920.34? Current yield = i (Par)/ P0 Discount bond current yield = $77.25 Number of semiannual payments = 26 (2) = 52 Future Value at maturity = $1.371. Copyright ©1997 by The Dryden Press All rights reserved 49-11 .000 Price = $1.000)/2 = $46.000)/2 = $60.34 Compute semiannual rate = 4.50 Compute semiannual rate = 4. However.0425)2 .090.00 Number of semiannual payments = 28 (2) = 56 Future Value at maturity = $1.371.26-year bond: Semiannual coupon payments = 9.000)/2 = $38.25% Nominal rate of return = 4.75% The current yield for the higher coupon bond is greater. the price of the annual coupon bond will be greater. the semiannual bonds would provide a higher value.68% b. Assume that James River Corporation's anticipated new 28 year 12% bond is not callable and sells for $1.34 = 8.56% 28-year bond: Semiannual coupon payments = 7. if you compute the price of an annual bond with a given coupon and a semiannual bond with a coupon half that of the annual bond.0425)2 .25% Nominal rate of return = 4.50% Effective annual rate = (1.19%(2) = 8. If both were discounted by the same effective annual rate. What is the nominal and effective annual YTM on this bond? Semiannual coupon payments = 12%($1.19% Nominal rate of return = 4.75 Number of semiannual payments = 28 (2) = 56 Future Value at maturity = $1. What is the current yield on this and the original 28 year bond selling for $920.1 = 8.75%($1. This is because you are discounting with a smaller nominal annual rate rather than the effective annual rate.

0. What is the expected total (percentage) return on each bond during the next year? Total return = current yield + capital gains yield Discount bond total yield = 8. e.09 . The price of the premium bond would decrease each year until it reached par at maturity. The lower price of the premium bond would result in a higher return.000 Required semiannual return = 8. Assuming the proposed 28 year bond is callable and sells for $1.25% Compute price = $921.000)/2 = $38. Since after-tax return is the relevant return. the premium bond would offer a higher before-tax YTM than the discount bond all other things equal.25% d.08% = 8.50%/2 = 4.00 Number of semiannual payments = 27 (2) = 54 Future Value at maturity = $1.25% = 8.000 Required semiannual return = 8.73 = .34) / $920. The current yield would decrease as the price increases.50% The discount bond has a lower current yield but has a capital gain.368. But on an after tax basis.34 = 0. current yield. What would happen to the price.42% + 0. The price of the discount bond would increase each year until it reached par at maturity.50%? What is the capital gains yields for the year for each bond assuming no change in interest rates? Price after one year: Discount bond: Semiannual coupon payments = 7.50% Premium bond total yield = 8. 49-12 . The taxes paid each year on the lower coupon bond would be lower and the larger capital gains would be deferred.26 .75%($1. and total return of each bond over time assuming constant future interest rates. investors would bid up the price of the discount bond and bid down the price of the premium bond.75% .c.368.$1. the yields would be identical to that of the marginal investor. In equilibrium.225. The current yield would increase as the price declines.50%/2 = 4.73)/ $1.0. The premium bond has a higher current yield but has a capital loss.000)/2 = $60. Total yield would remain the same.08% Premium bond CG yield = ($1.75 Number of semiannual payments = 27 (2) = 54 Future Value at maturity = $1.26 Capital Gains Yield Discount bond capital gains yield = ($921. what is the yield to first call? Do you think it is likely that the bond will be called? Explain how the probability of call affects the required yield on a bond.25% Compute price = $1. f.371. The yield to first call requires valuing the bond as if the bondholder will only hold the bond for 5 years and will receive a call premium of one year’s interest ($120) in addition to par at the time the Copyright ©1997 by The Dryden Press All rights reserved. The total return on each bond is the same and equal the required return. the investor would incur a larger present value total tax liability over the life of the bond if he or she bought the premium bond. Thus. What is each bonds expected price after one year assuming they both have a YTM of 8.371. 10.$920. Total yield would remain the same. If you were a tax-paying investor.09 Premium bond: Semiannual coupon payments = 12%($1. which bond would you prefer? Why? What impact would this preference have on the prices ( hence YTM) of the two bonds? An investor paying taxes would prefer the discount bond.

investors will require a slightly higher rate of return to compensate for the risk of not being able to hold the bond to maturity. therefore.95 % change --24.59% The change in price for the higher coupon bond is less than that for the lower coupon bonds for both the increase and decrease in required return. Which of the two long term bonds in Ms. Price risk is the risk incurred because a fixed income security (such as a bond) will lose some of its market value if interest rates rise. Because there is a probability that the bond will be called. Peabody's portfolio have the greatest price risk? Why? If you are using the case spreadsheet model. it is likely that the company will call the bond and issue new bonds as a lower coupon rate.225 Computed semiannual yield = 4.91 $1.235. Assume that you have money to invest in a bond but need the proceeds of the investment in 10 years. the longer the duration.000 + $120 = $1. Semiannual coupon payments = 12%($1. The longer term and lower coupon bonds have the greatest price risk.93% 39. Interest rate risk is a function of the bonds duration rather than its maturity. Coupon reinvestment rate risk is the risk incurred because the funds received from fixed income securities can only be invested at the current market rates rather than the YTM. It is composed of the weighted average of all coupon and maturity payments. Consider the risk of the bonds.120 Number of payments = 5 years (2) = 10 Present value or price = $1. As investors' required rates decrease. a. The lower the coupon rate the greater the sensitivity to interest rates changes. Required nominal rate 9% 12% 6% Price (26 year higher coupon bond) $1. c. where the weights are a function of the length of time to receive each payments. The longer the bonds term to maturity and the lower the coupon rate t.96 $789. you would not be affected by price risk. therefore. You would not receive coupon payments and. The longer the maturity of the bond the more a bonds price will be affected by a change in rates because of the compounding affect. b.000)/2 = $60 Future value (at call) = $1.bond is called. coupon rates are set at issue. You would receive the par value at the same time as you needed your funds and. illustrate your answer by calculating the change in value of each bond assuming the interest rates rose from the initial 9% to 12% and dropped from 9% to 6%. as less of the return is generated by the current rate and more through price changes. Explain the difference between interest rate price risk and coupon reinvestment rate risk. Duration is the average time the investors holds the asset.20 % change --22.425. As investors' required rates increase.19% (2) = 8. A bond with a duration equal to the 10 year investment Copyright ©1997 by The Dryden Press All rights reserved 49-13 .92 $659. the existing coupon will look more attractive and the bond price will increase.46% +41. the existing coupon will look less attractive and the bond price will drop.39 $1.024. 11. you would not be affected by needing to reinvest at the prevailing rate. Which type of bonds could you purchase to eliminate interest rate risk? A zero coupon bond with a 10 year maturity would eliminate interest rate risk.19% Nominal yield = 4.38% Given the high coupon level.05% Price (28 year lower coupon bond) $872. For example.

How would the results differ if she would have bought a longer term bond? If the bond had a longer term.000) / 2 = $45.25% Effective actual realized annual rate = 8. Then find the rate of return that equates the price with the terminal value. 12. 49-14 . Immediately after the bond was purchased. If interest rates fell these bonds would have greater price increases. What would happen if the interest rates increased rather than decreased? The actual realized rate would be higher because the coupons could be invested at a higher rate c. what type of bonds would you advise Ms. Peabody to purchase in order to maximize short-term capital gains? She should purchase longer-term. Computed semiannual rate 4.515.00 Number of payments = 5 ( 2) = 10 Compound rate = 6%/2 = 3% Compute future value coupons = $515.87 Future value of coupons plus par = $1. 13. With matching duration an increase in price due to a drop in interest rates would be exactly offset by the decrease in interest income from reinvested coupons at the lower rates. Many bond market participants are speculators as opposed to long-term investors.515.) How does the actual realized return compare with the expected rate of return? Find the terminal value of coupons Payment = 9% ( $1.87 Compute the compound rate that equates present value of $1.000 with future value of $1.87 over 10 periods with no annuity payments. An increase in interest rates would cause matching decrease in price and increase in investment income from coupons. the differences would be greater because more coupons would be invested at the new market rates for a longer period of time.horizon would also eliminate interest rate risk. a. Copyright ©1997 by The Dryden Press All rights reserved. If you thought interest rates were going to fall from current levels. lower coupon bonds as they are most sensitive to interest rate changes and will have the greatest interest rate risk. Given she can only invest her coupons at 6% what is the actual realized return on her investment? (Hint: Find the terminal (future) value of her coupons and the par value at maturity. b. market rates fell to 6%. Peabody sold some of her James River bonds and bought a 5 year 9% coupon bond selling at par.68% The actual realized rate is lower than the initial YTM because the coupons would be invested at a lower rate. Assume Ms.

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