Question

An investor must choose between two bonds:

Bond A pays $85 annual interest and has a market value of $850. It has 10 years to maturity.

Bond B pays $80 annual interest and has a market value of $780. It has five years to maturity.

Assume the par value of the bonds is $1,000.

a. Compute the current yield on both bonds. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

b. Which bond should she select based on your answers to part a?

• Bond B

• Bond A

c. A drawback of current yield is that it does not consider the total life of the bond. For example, the approximate yield to maturity on Bond A is 10.99 percent. What is the approximate yield to maturity on Bond B? The exact yield to maturity? (Use the approximation formula to compute the approximate yield to maturity and use the calculator method to compute the exact yield to maturity. Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

d. Has your answer changed between parts b and c of this question in terms of which bond to select?

• No

• Yes

Answer 1

Answer :

(a.) Calculation of Current Yield

Current Yield on Bond A = Annual Interest / Market Value

= 85 / 850

= 10.00%

Current Yield on Bond B = Annual Interest / Market Value

= 80 / 780

= 10.25%

(b.) Bond B should be selected as it has higher current yield .

(c.) Calculation of Approximate and Exact Yield to maturity

Calculation of Yield to maturity using Approximation formula :

YTM = {Coupon + [(Face value - Net Proceeds) / Number of years of maturity] } / [(Face value + Net Proceeds) / 2]

= {80 + [(1000 - 780) / 5] } / [(1000 + 780) / 2 ]

= 124 / 890

= 0.1393 or 13.93%

Calculation of Bond's Exact Yield to maturity

Using Financial calculator Rate function of Excel :

=RATE(nper,pmt,pv,fv)

nper is the number of years of maturity i.e 5

pmt is coupon payment i.e 80

pv is the current market price i.e 780

fv is the face value i.e 1000

=RATE(5,80,-780,1000)

Yield to maturity is 14.48%

(d.) No the answer has not changed as approximate yield to maturity of Bond B is more than that of Bond A.