Question

Congratulations, you have been hired as an analyst at the Procter and Gamble Co. (PG).  Your first assignment is to estimate the appropriate rate that a new 30-year bond would need in order to be issued competitively to the public.  It is April 1, 2020 (ignore actual current market rates).  PG just made a coupon payment (semi-annual) on its "8% 2045" bonds that mature on April 1, 2045. The bonds currently sell for 104 with a par value of 100.  Kimberly-Clark Corp. (KMB) has a 5% 2045 bond issue with a YTM of 6.0%. The PG and KMB bonds are identical in every way, including the Moody’s and S&P ratings, maturity date, and the fact that the respective companies can call them at any time. (The bonds were issued on different dates, thus their coupon rates and current market prices are different.)

            

a.         What is the yield to maturity on the PG bond?

            YTM    _______

b.         What is the price for the KMB bond?

            Price   _______

c.         Explain the difference in the YTM for the PG and KMB bonds.  Which bond provides the more accurate estimate of the rate required in the marketplace for PG at this time?  

d.         KMB has just issued a 5-year semi-annual bond with a 6% coupon, a par value of 100 and a 5% YTM.  Which KMB bond (5 year or 25 year) has the higher price risk and which one has the higher re-investment rate risk?   

(Circle 0ne)  Higher Price Risk                                            5 Year             25 Year

(Circle 0ne)  Higher Re-investment Rate Risk                  5 Year             25 Year

Answer 1

a]

YTM is calculated using RATE function in Excel with these inputs :

nper = 25*2 (25 years to maturity with 2 semiannual coupon payments each year)

pmt = 100 * 8% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -104 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 100 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE is calculated to be 3.82%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 7.64%

b]

Price of a bond is the present value of its cash flows. The cash flows are the coupon payments and the face value receivable on maturity

Price of bond is calculated using PV function in Excel :

rate = 6%/2 (Semiannual YTM of bonds = annual YTM / 2)

nper = 25 * 2 (25 years remaining until maturity with 2 semiannual coupon payments each year)

pmt = 100 * 5% / 2 (semiannual coupon payment = face value * coupon rate / 2)

fv = 100 (face value receivable on maturity)

PV is calculated to be $87.14

c]

The PG bond has a higher YTM than the KMB bond. This is due to the higher risk of PG bond perceived by bond investors. This could be due to poor financial health of PG relative to KMB

The PG bond provides the more accurate estimate of the rate required in the marketplace for PG at this time. This is because the yield on PG bonds best reflects the risk and required return for PG's bond investors

d]

Bonds with longer maturity have higher price risk, because their prices are more sensitive to changes in interest rates

Bonds with shorter maturity have higher reinvestment rate risk because at maturity, the bond proceeds must be reinvested. If the interest rates are lower at maturity, the proceeds must be reinvested at the lower interest rates.

5-year bond has higher reinvestment rate risk

2-year bond has higher price risk