Question

Week 2 Case studyMini Case Sam Strother and Shawna Tibbs. (Chapter 5, p,238). Please respond to the following questions, a, b, c, d, e (1); e(2); e(3). Please answer with a never used answer.

1. What are the key factors of a bond?
2. What are call provisions and sinking fund provisions? Do these provisions make bonds or less risky?
3. How does one determine the value of any asset whose value is based on expected future cash flow?
4. How is the value of a bond determined? What is the value of a 10-year, $1,000 per value bond with a 10% annual coupon if its required rate of returns is 10%?
5. (1) What would be the value of the bond described in Part d if, just after it had been issued, the expected inflation rate rose by 3% points, causing investors to require a 13% return? Would we now have a discount or a premium bond?

(2) What would happen to the bond’s value if inflation fell and r, declined to 7%? Would we now have a discount or a premium bond?

(3) What would happen to the value of the 10 year bond over time if the required rate of returns remained at 13%? If it remained at 7%? (Hint: With financial calculator, enter PMT, 1/YR,FV and N, and the changed N to see what happens to PV as the bond approaches maturity.)

Answer 1

1. Key factors of the bond are the following:

• Issue price: The amount at which a bond is issued by the issuer.
• Face value: The value on which interest is calculated. Usually, this is the amount repaid on maturity unless otherwise specified
• Coupon rate: Rate of interest of the bond (usually, on yearly basis)
• Coupon frequency: Frequency at which interest is paid. Amount of each interest payment at the coupon rate and the number of payments is dependant on this.
• Term to maturity

2. Call provision is the provision contained in the bond indenture enabling the issuer to repay the bond before maturity

Sinking fund provision makes it mandatory for the issuer to accumulate required amount for redemption of the bond, fully or partly, over the term to maturity.

Sinking fund provision reduces the risk. Call provision has no effect on risk but is disadvantageous to the investor since, in the even of fall in interest rates, the issuer may recall the bond.

(c ) Value of an asset whose value is determined based on future cash flows is by discounting the future cash flows. The discount rate used is the expected rate of return.

(d ) Value of a bond is determined as the sum of present values of future coupon payments and the redemption value. Discount rate used is the market interest rate which will be the YTM

Since the expected return is equal to coupon rate, value of the stated bond is equal to par value as follows:

(e) (1) Value of the bond consequent to increase in interest required to 13% is $837.212696. The bond is now on discount

(e)(2)  Value of the bond consequent to decrease in interest required to 7% is $1124.749080. The bond is now on premium.

Details of the above calculations, using the PV function of Excel, is as follows:

(e)(3) If the rate of return required remained at 13%, over the period till maturity, the value might have increased gradually, reducing the discount and eventually become equal to face value on the maturity date.

Similarly, if the rate of return required remained at 7%, over the period till maturity, the value might have decreased gradually, reducing the premium and eventually become equal to face value on the maturity date