Question

Question 1

(show main workings)

1.1) A 15 year bond with a R1,000 face value and a 6% annual coupon pays interest

        annually. The bond will mature in 10 years. The nominal yield to maturity is 5%.

    a) What is the price of the bond today?

b) What is the current yield of the bond?                                                                                 

         

c) Yachna Equipment Company recently paid a dividend of R2.30. The company's  

    policy is to allow its dividend to grow at 4% per year indefinitely. What is the value of the share

    if the required rate of return is 10%?     

d) What are the two types of risks associate with corporate bonds? (2)

1.2) As a financial advisor, Yachna needs your advice on the following two options:

       a) Receive a lump sum of R800 000 now or

       b) Receive R180 000 over the next 5 years, assuming discount rate is 6%.

        Which option is advisable? Show the necessary calculations.(5)

    

                                                                       

1.3) John is currently 53 years old and is considering buying an apartment in a retirement village. The apartment is currently selling at R1 200 000 and the estate agent informs him that the value of the house will increase by 6% per annum. He decides that he will invest a fixed amount every end of the year until he retires at the age of 65 years. The bank offers a compound rate of 10% per annum for his investments.

a)What will the house cost when John retires at age 65?   

b)How much must he invest at the end of each year to be able to make the cash payment at retirement.

Answer 1

1.1

(a) Calculation of price of bond today

n= 10

ytm=5%

coupon rate = 6 %

face value =1000

Price of bond will be calculated using the following formula

price= 6% of 1000* PVIFA (5%,10)+ 1000* PVIF(5%, 10)

= 60*7.7217+1000*0.6139

=463.302+613.90

=1077.202

(b) Calculation of Current yield

current yield can be calculated using the following formula

current yield = (coupon interest/ market price)*100

=(1000*6%/1077.202)*100

=(60/1077.202)*100

=5.57%

(c) Calculation of value of share when dividend, growth rate and required rate of return is given

dividend=2.30

growth rate= 4%

required rate of return=10%

Value of share can be calculated using the following formula

V₀ =(d₀(1+g))/(r-g)

=(2.30(1+.04))/.(.10-.04)

=(2.392/.06)

=39.8666

(d) Two Types of risk associated with the corporate bonds

Bonds that are issued by corporations are called corporate bonds.They usually have high rate of interest and also  have higher risk compared to the goverment bonds.

There are different risk associated with the corporate bond. Two risk associated with corporate bonds are discussed below:-

1. Credit Risk
2. Interest Rate Risk

CREDIT RISK

Credit risk is  defined as the risk of loss as a result of not getting the full interest as well as principal payments from the borrower. It is calculated on the basis of borrowers overall ability to repay the loan according to the terms of contract. The credit risk of a lender is usually assessed using the five C's which include credit history, capacity to repay, capital, the  condition on which lender or borrower is granted loan and the collateral associated with the loan.

INTEREST RATE RISK

There is a inverse relation between interest rate and the price of bond. With the increase in interest rate there will be a decrease in price of bond. So interest rate risk may be defined as the risk that the price of bond may decrease with the increase in the interest rate. However the interest rate risk can be reduced through diversification of bond maturities and can even be hedged using interest rate derivatives