Question

. Lynn Parsons is considering investing in either of two outstanding bonds. The bonds both have $1000 par values and 11 % coupon interest rates and pay annual interest. Bond A has exactly 9 years to maturity, and bond B has 19 years to maturity. a. Calculate the present value of bond A if the required rate of return is: (1) 8 %, (2) 11 %, and (3) 14 %. b. Calculate the present value of bond B if the required rate of return is: (1) 8 %, (2) 11 %, and (3) 14 %. c. From your findings in parts a and b , discuss the relationship between time to maturity and changing required returns. d. If Lynn wanted to minimize interest rate risk, which bond should she purchase? Why?

Answer 1

Present Value of Bond A,

1.Required Return is 8%, Present Value = 110*PVAF(8%, 9 years) + 1000*PVF(8%, 9 years)

= 110*6.247 + 1,000*0.500

= $1,187.17

2. Required Return is 11%, Present Value = 110*PVAF(11%, 9 years) + 1000*PVF(11%, 9 years)

= 110*5.537 + 1,000*0.391

= $1,000

3. Required Return is 14%, Present Value = 110*PVAF(14%, 9 years) + 1000*PVF(14%, 9 years)

= 110*4.946 + 1,000*0.308

= $852.06

b.Present Value of Bond B

Required Return is 8%, Present Value = 110*PVAF(8%, 19 years) + 1000*PVF(8%, 19 years)

= 110*9.604 + 1,000*0.232

= $1,288.44

Required Return is 11%, Present Value = 110*PVAF(11%, 19 years) + 1000*PVF(11%, 19 years)

= 110*7.839 + 1,000*0.138

= $1,000.29

Required Return is 14%, Present Value = 110*PVAF(14%, 19 years) + 1000*PVF(14%, 19 years)

= 110*6.550 + 1,000*0.083

= $803.5

c. As the time to maturity increases, Bond value changes more to changes in required returns

d.If interest rate risk is to be minimised, Bond A should be purchased, since it is for a shorter period and value changes less with changes in interest rates.