Question

Airnova Inc. has two types of bonds, Bond D and Bond F. Both have 8 percent coupons, make semiannual payments, and are priced at par value. Bond D has 2 years to maturity. Bond F has 15 years to maturity. Airnova Inc. is considering four different types of stocks. They each have a required return of 20 percent and a dividend of $3.75 for share. Stocks, A, B, and C are expected to maintain constant growth rates in dividends for the near future of 10 percent, 0 percent, and -5 percent, respectively. Stock D is a growth stock and will increase its dividend by 30 percent for the next four years and then maintain a constant 12 percent growth rate after that.

• If interest rates suddenly rise by 2 percent, what is the percentage change in both bonds?

• If interest rates suddenly fall by 2 percent, what is the percentage change in both bonds?

• What does this tell you about the interest rate risk of longer-term bonds?

Answer 1

There are two bonds, Bond D and F.

Both the bonds are exchanging at standard. Considering standard incentive to be 1000.

The YTM of the security is equivalent to Coupon Rate when the security exchanges at standard. So the cost of the bond currently is $1,000 and its future incentive on development will likewise be $1,000.

You have to utilize monetary adding machine for this issue, you can download it.

Security D-If the Interest rate increases by 2%. So prior the loan fee was 8%, presently it will be 10%

Strokes in Financial Calculator

N = 2 (The development of the bobd is for a long time)

I/Y = 10 (Earlier it was exchanging at standard, so it ought to have been equivalent to coupon rate, that is 8%, yet now it has expanded by 2%, so 10)

PMT - 80 (This is the coupon installment, that is 8% of 1000)

FV - 1000 (Future Value of the bond stays consistent, that is it will pay 1000 on development)

CPT + PV = 965.3 (So prior the cost of the security was 1000, yet as we realize that cost of the security is conversely identified with Interest rate change, so as the loan fee expanded, so the value fell)

Prior the cost was 1000 and now it is 965.3. So % fall is

(1,000 - 965.3)/1000 * 100 = 3.47%. So the cost of bond fell by 3.47%

Presently coming to Bond F, everything is same, just the development is extraordinary. So keep all the information unblemished in your mini-computer and just change the N from 2 to 15.

So we are attempting to see the effect of value change if the loan cost rises.

In number cruncher:

N - 15 (Earlier it was 2 and now it is 15)

I/Y - 10 ( Same as above)

PMT - 80 (Same as above)

FV - 1000 (Same as above)

CPT + PV = 847.8 (So if the loan fee changes from 8% to 10%, the cost of bond decresaes from 1000 to 847.8)

So the absolute decrease in bond cost is

(1000 - 847.8)/1000 * 100 = 15.22%

So you can consider that to be Bond F has more prominent development, so the fall in bond cost was more noteworthy in Bond F.

Thus keeping everything else contant, in the event that the financing cost would have decresaed rather than increment, at that point

BOND D

In number cruncher:

N = 2 ( As development is of 2 years)

I/Y = 6 ( Eralier it was 8% as 2 % decline so it is 6% now)

PMT - 80 (Coupon at 8%)

FV - 1000 ( Future worth stays fixed at 1000)

CPT + PV = 1036 ( As the financing cost fell, so the bond cost expanded from 1000 to 1036)

Rate increment in security cost = (1036 - 1000)/1000 * 100

= 3.6%

BOND F

If there should arise an occurrence of BOND F, the main contrast is the development.

So in mini-computer simply change the N from 2 to 15.

N = 15

CPT + PV = 1194 ( As the loan cost fell, so the bond cost expanded from 1000 to 1194)

Rate increment in Bond Price is (1194 - 1000)/1000 * 100

= 19.4%

By observing the adjustment in security value, you can establish that securities with longer development is increasingly inclined to financing cost hazard. The adjustment in security cost for longer development with 2% change in financing cost is - 15.2% to + 19.4%. On account of transient bond ,the vacillation was - 3.47% to +3.6%