AFW360 Corporate Finance

Tutorial 2: Problem Sets

Dr. Gary John Rangel

School of Management
 Chapter 8 Concept Question 15
The 100-year bonds we discussed in the chapter have something in common
with junk bonds. Critics charge that, in both cases, the issuers are really selling
equity in disguise. What are the issues here? Why would a company want to
sell “equity in disguise”?

Answer:
A 100-year bond looks like a share of preferred stock. In particular, it is a loan
with a life that almost certainly exceeds the life of the lender, assuming that the
lender is an individual. With a junk bond, the credit risk can be so high that the
borrower is almost certain to default, meaning that the creditors are very likely to
end up as part owners of the business. In both cases, the “equity in disguise”
has a significant tax advantage.
 Chapter 8 Problem 1
What is the price of a 20-year, zero coupon bond paying $1,000 at maturity,
assuming semiannual compounding, if the YTM is:
a. 6 percent?
b. 8 percent?
c. 10 percent?
 Chapter 8 Problem 1
Answer:
(a)
𝐹
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 =
1+𝑟 𝑇
$1,000
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 40
0.06
1+
2
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $306.56

(b)
$1,000
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 40
0.08
1+
2
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $208.29
 Chapter 8 Problem 1
Answer:
(c)
𝐹
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 =
1+𝑟 𝑇
$1,000
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 40
0.10
1+
2
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $142.05
 Chapter 8 Problem 1
Answer:
(a) Alternative solution using financial calculator model Texas Instruments
BA II Plus
Keystrokes Display Description
40, N N = 40.00 Enter the number of
compounding periods
3, I/Y I/Y = 3.00 Enter semi-annual interest
rate
0, PMT PMT = 0.00 Enter semi annual coupon
payments
1,000, FV FV = 1,000.00 Enter par value at maturity
CPT, PV PV = -306.56 Compute present value
 Chapter 8 Problem 1
Answer:
(b) Alternative solution using financial calculator model Texas Instruments
BA II Plus
Keystrokes Display Description
40, N N = 40.00 Enter the number of
compounding periods
4, I/Y I/Y = 4.00 Enter semi-annual interest
rate
0, PMT PMT = 0.00 Enter semi annual coupon
payments
1,000, FV FV = 1,000.00 Enter par value at maturity
CPT, PV PV = -208.29 Compute present value
 Chapter 8 Problem 1
Answer:
(c) Alternative solution using financial calculator model Texas Instruments
BA II Plus
Keystrokes Display Description
40, N N = 40.00 Enter the number of
compounding periods
5, I/Y I/Y = 5.00 Enter semi-annual interest
rate
0, PMT PMT = 0.00 Enter semi annual coupon
payments
1,000, FV FV = 1,000.00 Enter par value at maturity
CPT, PV PV = -142.05 Compute present value
 Chapter 8 Problem 3
Watters Umbrella Corp. issued 15-year bonds two years ago at a coupon
rate of 6.2 percent. The bonds make semiannual payments. If these bonds
currently sell for 98 percent of par value, what is the YTM?
Answer:
1
1− 𝐹
1+𝑅 𝑡
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 1+𝑅 𝑡
1
1−
𝑌𝑇𝑀 26
1+ $1,000
$980 = $31 × 2 +
𝑌𝑇𝑀Τ2 𝑌𝑇𝑀 26
1+
2
 Chapter 8 Problem 3
Answer:
Solution using financial calculator model Texas Instruments BA II Plus
Keystrokes Display Description
26, N N = 26.00 Stores the number of
compounding periods
980, +/-,PV PV = -980.00 Stores present value
1,000, FV FV = 1,000.00 Stores par value at maturity
31, PMT PMT = 31 Stores semi-annual coupon
payment
CPT, I/Y I/Y = 3.21 Enter semi-annual interest rate
Since this is the semiannual YTM, the annual YTM is:
2 × 3.215= 6.43%
 Chapter 8 Problem 9
Union Local School District has bonds outstanding with a coupon rate of 2.9
percent paid semi-annually and 12 years to maturity. The yield to maturity on
these bonds is 3.4 percent and the bonds have a part value of $5,000. What
is the dollar price of each bond?
Answer:
1
1− 𝐹
1+𝑅 𝑡
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 1+𝑅 𝑡
1
1−
0.034 24
1+ $5,000
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $72.5 × 2 +
0.034Τ2 0.034 24
1+
2
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $1,419.024877 + $3,336.315662 = $4,755.34
 Chapter 8 Problem 9
Answer:
Solution using financial calculator model Texas Instruments BA II Plus
Keystrokes Display Description
24, N N = 24.00 Stores the number of
compounding periods
1.7, I/Y I/Y = 1.7 Enter semi-annual interest rate
5,000, FV FV = 5,000.00 Stores par value at maturity
72.5, PMT PMT = 72.5 Stores semi-annual coupon
payment
CPT, PV PV = -4,755.34 Compute present value
The dollar price of each bond is $4,755.34.
 Chapter 8 Problem 12
An investment offers a total return of 12 percent over the coming year. Jerome
Dowell thinks the total real rate return on this investment will be only 7 percent.
What does Jones believe the inflation rate will be over the next year?
Answer:
1+𝑅 = 1+𝑟 × 1+ℎ
1 + 0.12 = 1 + 0.07 × 1 + ℎ
1.12 = 1.07 × 1 + ℎ
1.12
=1+ℎ
1.07
1 + ℎ = 1.046728972
ℎ = 1.046728972 − 1
ℎ = 0.046728972 = 4.67%
Jones believes the inflation rate will be 4.67% over the next year.
 Chapter 8 Problem 20
Hacker Software has 5.9 percent coupon bonds on the market with 13 years
to maturity. The bonds make semiannual payments and currently sell for 104
percent of par. What is the current yield on the bonds? The YTM? The
effective annual yield?
Answer:
Current yield of the bond
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
0.059 × $1,000 59
= = 0.0567 = 5.67%
$1,000 × 1.04 1,040
The current yield on the bonds is 5.67%
 Chapter 8 Problem 20
Answer:
YTM of the bond
1
1− 𝐹
1+𝑅 𝑡
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 1+𝑅 𝑡
1
1−
𝑌𝑇𝑀 26
1+ $1,000
$1,040 = $29.5 × 2 +
𝑌𝑇𝑀 2Τ 26
𝑌𝑇𝑀
1+
2
 Chapter 8 Problem 20
Answer:
Solution using financial calculator model Texas Instruments BA II Plus
Keystrokes Display Description
26, N N = 26.00 Stores the number of
compounding periods
1,040, +/-, PV PV = -1,040.00 Stores present value
1,000, FV FV = 1,000.00 Stores par value at maturity
29.5, PMT PMT = 29.50 Stores semi-annual coupon
payment
CPT, I/Y I/Y = 2.735 Compute semi-annual interest
rate

The semi-annual YTM is 2.735%. Therefore, the annual YTM is 2.735% x 2

= 5.47%
 Chapter 8 Problem 20
Answer:
𝑟 𝑚
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = 1 + −1
𝑚
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = 1 + 0.02735 2 − 1 = 0.0554 = 5.54%
 Chapter 8 Problem 29
Bond P is a premium bond with a coupon of 8 percent. Bond D has a coupon
bond of 5 percent and is selling at a discount. Both bonds make annual
payments, have a YTM of 6.5 percent, and have 10 years to maturity. What is
the current yield for Bond P? For Bond D? If the interest rates remain
unchanged, what is the expected capital gains yield over the next year for Bond
P? For Bond D? Explain your answers and the interrelationship among the
various types of yields.
Answer:
Step 1: Find the bond price for Bond P
1
1− 𝐹
1+𝑅 𝑡
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 1+𝑅 𝑡
1
1− $1,000
1 + 0.065 10
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $80 × +
0.065 1 + 0.065 10
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $575.1064178 + $532.7260355 = $1,107.83
 Chapter 8 Problem 29
Answer:
Step 2: Find the bond price for Bond D
1
1− 𝐹
1+𝑅 𝑡
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 1+𝑅 𝑡
1
1− $1,000
1 + 0.065 10
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $50 × +
0.065 1 + 0.065 10
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $359.4415111 + $532.7260355 = $892.17
Step 3: Calculate current yield for Bond P.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
$80
= 0.0722 = 7.22%
$1,107.83
The current yield on the bonds is 7.22%
 Chapter 8 Problem 29
Answer:
Step 4: Calculate current yield for Bond D.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
$50
= 0.0560 = 5.60%
$892.17
The current yield on the bonds is 5.60%
Step 5: Calculate the price of Bond P one year from now.
1
1− $1,000
1 + 0.065 9
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $80 × +
0.065 1 + 0.065 9
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $532.488355 + $567.3532278 = $1,099.84
Step 6: Calculate the price of Bond D one year from now.
1
1− $1,000
1 + 0.065 9
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $50 × +
0.065 1 + 0.065 9
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $332.8052094 + $567.3532278 = $900.16
 Chapter 8 Problem 29
Answer:
Step 7: Calculate capital gain for Bond P and D.
𝑁𝑒𝑤 𝑝𝑟𝑖𝑐𝑒 − 𝑂𝑙𝑑 𝑝𝑟𝑖𝑐𝑒
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 =
𝑂𝑙𝑑 𝑝𝑟𝑖𝑐𝑒
$1,099.84 − $1,107.83
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 𝐵𝑜𝑛𝑑 𝑃 = = −0.0072 = −0.72%
$1,107.83
$900.16 − $892.17
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 𝐵𝑜𝑛𝑑 𝐷 = = 0.0090 = 0.90%
$892.17

All else held constant, premium bonds pay a high current income while
having price depreciation as maturity nears; discount bonds pay a lower
current income but have price appreciation as maturity nears. For either
bond, the total return is still 6.5 percent, but this return is distributed
differently between current income and capital gains.
 Chapter 8 Problem 29
Answer:
Solution using financial calculator model Texas Instruments BA II Plus
Step 1: Find the bond price for Bond P
Keystrokes Display Description
10, N N = 10.00 Stores the number of
compounding periods
6.5, I/Y I/Y = 6.50 Stores annual interest rate
1,000, FV FV = 1,000.00 Stores par value at maturity
80, PMT PMT = 80.00 Stores annual coupon payment
CPT, PV PV = -1,107.83 Compute present value

The price of Bond P is $1,107.83

 Chapter 8 Problem 29
Answer:
Solution using financial calculator model Texas Instruments BA II Plus
Step 2: Find the bond price for Bond D
Keystrokes Display Description
10, N N = 10.00 Stores the number of
compounding periods
6.5, I/Y I/Y = 6.50 Stores annual interest rate
1,000, FV FV = 1,000.00 Stores par value at maturity
50, PMT PMT = 80.00 Stores annual coupon payment
CPT, PV PV = -892.17 Compute present value

The price of Bond D is $892.17

 Chapter 8 Problem 29
Answer:
Step 3: Calculate current yield for Bond P.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
$80
= 0.0722 = 7.22%
$1,107.83
The current yield on the bonds is 7.22%
Step 4: Calculate current yield for Bond D.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
$50
= 0.0560 = 5.60%
$892.17
The current yield on the bonds is 5.60%
 Chapter 8 Problem 29
Answer:
Solution using financial calculator model Texas Instruments BA II Plus
Step 5: Find the bond price for Bond P
Keystrokes Display Description
9, N N = 9.00 Stores the number of
compounding periods
6.5, I/Y I/Y = 6.50 Stores annual interest rate
1,000, FV FV = 1,000.00 Stores par value at maturity
80, PMT PMT = 80.00 Stores annual coupon payment
CPT, PV PV = -1,099.84 Compute present value

The price of Bond P is $1,099.84

 Chapter 8 Problem 29
Answer:
Solution using financial calculator model Texas Instruments BA II Plus
Step 6: Find the bond price for Bond D
Keystrokes Display Description
9, N N = 9.00 Stores the number of
compounding periods
6.5, I/Y I/Y = 6.50 Stores annual interest rate
1,000, FV FV = 1,000.00 Stores par value at maturity
50, PMT PMT = 80.00 Stores annual coupon payment
CPT, PV PV = -900.16 Compute present value

The price of Bond D is $900.16

 Chapter 8 Problem 29
Answer:
Step 7: Calculate capital gain for Bond P and D.
𝑁𝑒𝑤 𝑝𝑟𝑖𝑐𝑒 − 𝑂𝑙𝑑 𝑝𝑟𝑖𝑐𝑒
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 =
𝑂𝑙𝑑 𝑝𝑟𝑖𝑐𝑒
$1,099.84 − $1,107.83
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 𝐵𝑜𝑛𝑑 𝑃 = = −0.0072 = −0.72%
$1,107.83
$900.16 − $892.17
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 𝐵𝑜𝑛𝑑 𝐷 = = 0.0090 = 0.90%
$892.17

All else held constant, premium bonds pay a high current income while
having price depreciation as maturity nears; discount bonds pay a lower
current income but have price appreciation as maturity nears. For either
bond, the total return is still 6.5 percent, but this return is distributed
differently between current income and capital gains.
 Chapter 8 Problem 34
You are planning to save for retirement over the next 30 years. To save for
retirement, you will invest $900 per month in a stock account in real dollars
and $300 a month in a bond account in real dollars. The effective annual
return of the stock account is expected to be 12 percent and the bond
account will earn 7 percent. When you retire, you will combine your money
into an account with an effective return of 8 percent. The inflation rate over
this period is expected to be 4 percent. How much can you withdraw each
month from your account in real terms assuming a withdrawal period of 25
years? What is the nominal dollar amount of your last withdrawal?
Answer:
Step 1: Calculate the real rate of return for the stock account.
1+𝑅 = 1+𝑟 × 1+ℎ
1 + 0.12 = 1 + 𝑟 × 1 + 0.04
1.12 = 1 + 𝑟 1.04
1.12
1+𝑟 = = 1.076923077
1.04
𝑟 = 1.076923077 − 1 = 0.0769 = 7.69%
 Chapter 8 Problem 34
Answer:
Step 2: From the real rate of return, calculate the annual percentage rate
(APR) for the stock account.
1
𝐴𝑃𝑅 = 𝑚 1 + 𝐸𝐴𝑅 𝑚 −1
1
𝐴𝑃𝑅 = 12 1 + 0.0769 12 − 1 = 0.0743 = 7.43%
Step 3: Calculate the real rate of return for the bond account.
1+𝑅 = 1+𝑟 × 1+ℎ
1 + 0.7 = 1 + 𝑟 × 1 + 0.04
1.07 = 1 + 𝑟 1.04
1.07
1+𝑟 = = 1.028846154
1.04
𝑟 = 1.0 − 1.028846154 = 0.0288 = 2.88%
Step 4: From the real rate of return, calculate the annual percentage rate
(APR) for the bond account.
1
𝐴𝑃𝑅 = 𝑚 1 + 𝐸𝐴𝑅 𝑚 −1
1
𝐴𝑃𝑅 = 12 1 + 0.0288 12 − 1 = 0.0284 = 2.84%
 Chapter 8 Problem 34
Answer:
Step 5: Monthly rate for the stock account.
𝐴𝑃𝑅
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑟𝑎𝑡𝑒 =
12
0.0743
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑟𝑎𝑡𝑒 = = 0.006191 = 0.62%
12
Step 6: Monthly rate for the bond account.
0.0284
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑟𝑎𝑡𝑒 = = 0.002367 = 0.24%
12
Step 7: Find the future value of the annuity payment into the stock account.
1+𝑟 𝑡−1
𝐹𝑉 = 𝐶
𝑟
1 + 0.0062 360 − 1
𝐹𝑉 = $900 = $1,198,232.99
0.0062
Step 8: Find the future value of the annuity payment into the bond account.
1 + 0.0024 360 − 1
𝐹𝑉 = $300 = $171,272.19
0.0024
 Chapter 8 Problem 34
Answer:
Step 9: Add the future values found in Step 7 & 8.
$1,198,232.99 + $171,272.19 = $1,369,505.18
Step 10: Find the monthly interest rate after retirement
1+𝑅 = 1+𝑟 × 1+ℎ
1 + 0.8 = 1 + 𝑟 × 1 + 0.04
1.08 = 1 + 𝑟 1.04
1.08
1+𝑟 = = 1.038461538
1.04
𝑟 = 1 − 1.038461538 = 0.03846 = 3.85%
Step 11: From the real rate of return, calculate the annual percentage rate
(APR) for the combined account.
1
𝐴𝑃𝑅 = 𝑚 1 + 𝐸𝐴𝑅 𝑚 −1
1
𝐴𝑃𝑅 = 12 1 + 0.0385 12 − 1 = 0.0378 = 3.78%
 Chapter 8 Problem 34
Answer:
Step 12: Monthly rate for the combined account.
𝐴𝑃𝑅
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑟𝑎𝑡𝑒 =
12
0.0378
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑟𝑎𝑡𝑒 = = 0.00315 = 0.315%
12
Step 13: Find the amount that can be withdrawn in real terms monthly over a
period of 25 years.
1 1
𝑃𝑉 = 𝐶 −
𝑟 𝑟 1+𝑟 𝑡
1 1
$1,369,505.18 = 𝐶 −
0.00315 0.00315 1 + 0.00315 300
$1,369,505.18 = 𝐶 317.4603175 − 123.5737425
$1,369,505.18 = 193.886575𝐶
$1,369,505.18
𝐶= = $7,063.43
193.886575
 Chapter 8 Problem 34
Answer:
Step 14: Find the nominal value of the last withdrawal.
𝐹𝑉 = 𝑃𝑉 × 1 + 𝑟 𝑡
𝐹𝑉 = $7,063.43 × 1 + 0.04 30+25
𝐹𝑉 = $61,073.01
The nominal value of the last withdrawal is $61,073.01.
 Chapter 8 Problem 34
Answer:
Alternative solution using financial calculator model Texas Instruments BA II
Plus.
Step 7: Find the future value of the annuity payment into the stock account.
Keystrokes Display Description
360, N N = 360.00 Stores the number of
compounding periods
0.62, I/Y I/Y = 0.62 Stores monthly interest rate
900, PMT PMT = 900.00 Stores monthly payment
0, PV PV = 0.00 Stores present value
CPT, FV FV = -1,198,232.99 Compute future value
 Chapter 8 Problem 34
Answer:
Alternative solution using financial calculator model Texas Instruments BA II
Plus.
Step 7: Find the future value of the annuity payment into the bond account.
Keystrokes Display Description
360, N N = 360.00 Stores the number of
compounding periods
0.24, I/Y I/Y = 0.24 Stores monthly interest rate
300, PMT PMT = 300.00 Stores monthly payment
0, PV PV = 0.00 Stores present value
CPT, FV FV = -171,272.19 Compute future value
 Chapter 8 Problem 34
Answer:
Alternative solution using financial calculator model Texas Instruments BA II
Plus.
Step 13: Find the amount that can be withdrawn in real terms monthly over a
period of 25 years.
Keystrokes Display Description
300, N N = 300.00 Stores the number of
compounding periods
0.315, I/Y I/Y = 0.315 Stores monthly interest rate
1,369,505.18, PV PV = 1,369,505.18 Stores present value
0, FV FV = 0.00 Stores future value
CPT, PMT PMT = -7,063.43 Computes monthly payment
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