Question

Corporate Financial Management

Question 2 :

1. If you purchase a 5-year zero-coupon bond for $500, how much could it be sold for 3 years later if interest rates have remained stable? The par value of this bond is $1000.
2. How much would an investor need to receive in nominal return if he desires a real return of 4% and the rate of inflation is 5%?

3. What is the realized rate of return for an investor who pays $1,054.47 for a 3-year bond with a 7% coupon and sells the bond 1 year later for $1,037.19? The par value of this bond is $1000.

4. An investor is convinced that a corporation has a potential competitive advantage in its market sector and a capacity to realize this advantage. Nevertheless, she is concerned that corporate management may choose to pursue a less risky strategy and not to fully realize the potential of the firm. Discuss the difficulty faced by this investor. Are you aware of any arrangements which might better align the interests of this investor and management? Describe and evaluate such arrangements. Remarks: 1. Application of correct formulae-All workings/calculations must be shown clearly and in full .Motivate and criticise formula adopted. 2.Explanation of results -Detailed and clear explanation of your overall solution in each question part.

Answer 1

(a) Tenure of Zero Coupon Bond = 5 years, Purchase Price = $ 500 and Par Value = $ 1000, Let the Sale Price after 3 Years = $ P3

Let the interest rate be R %

500 = 1000 / (1+R)^(5)

R = [(1000/500)^(1/5)] - 1 = 0.148698 or 14.8698 %

If the interest rate remains 14.8698 % , then 500 = P3 / (1.148698)^(3)

P3 = 500 x ((1.148698)^(3)) = $ 757.8576 ~ $ 757.86

(b) Real Return = 4 % and Rate of Inflation = 5 %

Nominal Rate of Return = [(1+Real Return) x (1+ Rate of Inflation)] - 1 = [(1.04) x (1.05)] - 1 = 0.092 or 9.2 %

(c) Purchase Price = $ 1054.47 and Sale Price = $ 1037.19, Holding Tenure = 1 year, Bond Coupon Rate = 7 % and Par Value = $ 1000

Annual Coupon = 1000 x 0.07 = $ 70

Realized Rate of Return = [(1037.19 + 70) - 1054.47] / 1054.47 = 0.049997 or 4.9997 ~ 4.99 %

NOTE: Please raise a separate query for the solution to the last unrelated question, as one query is restricted to the solution of only complete question (or up to 4 related sub-parts)