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Q2: Bond Valuation   Consider the following bonds issued by Romana Co to raise $50m. The two...

Q2: Bond Valuation  

Consider the following bonds issued by Romana Co to raise $50m. The two bonds have a 10-year maturity and face value of $1000.  

  • Bond A is a coupon- paying bond with coupon rate of 6% paid annually
  • Bond B is a zero- coupon bond

Required:

  1. Estimate the price of bond A & B at 2% yield to maturity.
  2. If yield to maturity rise from 2 to 2.5 %. Re-estimate the price of bond A & B at 2.5%.
  3. As an investor which bond would you prefer and why?

Solutions

Expert Solution

(a): Price of a bond = present value of its cash flow.

Bond A: coupon payments = 6% of $1000 = $60. This will be the cash flow from years 1 to 9. In 10th year cash flow = 60+1000 = 1060

Thus price = 60/1.02 + 60/1.02^2 + 60/1.02^3+.......60/1.02^9+1060/1.02^10

= $1,359.30

Price of Bond B = 1000/1.02^10

= $820.35

(b): Here the price of Bond A = 60/1.025 + 60/1.025^2 + 60/1.025^3+.......60/1.025^9+1060/1.025^10

= $1,306.32

Price of Bond B = 1000/1.025^10

= $781.20

(c): As an investor I will prefer investing in the zero coupon bonds. From the calculations we can see that the zero coupon bonds can be purchased at a deep discount when compared to their face value. Secondly it comes with minimal risks. Moreover I will not have to pay taxes on the interest received as the zero coupon bonds are issued at a discounted price and redeemed at face value. In case of investing in bonds that pay coupons I will have to pay taxes on the coupons/interest received by me. Also the holding period return of the zero coupon bonds will be equal to its YTM if held till maturity. This will not be the case for the bond paying coupons whose holding period return will be less than YTM.


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