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A. What are the key features of a bond?

1. Convertible Bonds - ​A feature of convertible bonds that allows bondholders to

change each bond into a stated number of shares of common stock.

2. Call Feature - ​A feature included in nearly all corporate bond issues that give the

issuer the opportunity to repurchase bonds at a stated call price prior to maturity.

3. Stock Purchase Warrants - Instruments that give their holders the right to

purchase a certain number of shares of the issuer’s common stock at a specified

price over a certain period of time.

B. What are call provisions and sinking fund provisions? Do these provisions make

bonds more or less risky?

A call provision is an option built into some bond indentures​, allowing the issuer to

redeem bonds prior to their scheduled maturity dates in exchange for a premium over the face

value of the bonds. The issuer uses this provision when interest rates decline so that it can

re-issue new bonds that offer a lower interest rate. The presence of a call provision makes a bond

less valuable to investors since their ability to earn a high return for a protracted period of time

could be curtailed, thus makes callable bonds riskier. Consequently, bonds with call provisions

typically trade at a higher effective interest rate​, to compensate investors for their uncertain

future return on investment.

A sinking-fund provision is a restrictive provision often included in a bond indenture,

providing for the systematic retirement of bonds prior to their maturity. It is a requirement for

certain bond issuers to buy back a portion of its debt at regular intervals. The bonds can be
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bought by the issuer on the secondary market or directly from bondholders. A sinking fund

provision makes a bond issue simultaneously more attractive to an investor (through the

decreased risk of default at maturity) and less attractive (through the repurchase risk associated

with the sinking fund price).

C. How is the value of any asset whose value is based on expected future cash flows

determined?

The value of any asset depends on the cash flow(s) it is expected to provide over the

ownership period. To have value, an asset does not have to provide an annual cash flow; it can

provide intermittent cash flow or even a single cash flow over the period. For example Stock in

GDD Enterprise expects to receive cash dividends of $400 per year indefinitely. Oil Well

expects to receive a cash flow of $1,000 at the end of year 1, $4,000 at the end of year 2, and

$10,000 at the end of year 4, when the well is to be sold.

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D. How is the value of a bond determined? What is the value of a 10-year, $1000 par

value bond with a 10 percent annual coupon if its required rate of return is 10

percent?

The value of a bond is the present value of the payments its issuer is contractually

obligated to make, from the current time until it matures. The formula for the value of the bond

is:

B0 = 100 ( 6.1446 ) + 1,000 ( 0.3855 )

B0 = 614.46 + 385.50

B0 = $ 999.96
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E. 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 percentage points, causing investors to

require a 13 percent return? Would we now have a discount or a premium bond?

We will have a discount bond because the present value of the bond is below its

par value.

​ FV= $1000 MR= 13% n= 10 yrs CR= 10%

FV
PV​B​= PMT (PVIFA​i, n​) + (1+i)
n [PMT= 1000 × 0.1= $100]

1000
PV​B​= 100 (PVIFA​13%, 10​) + (1+0.13)10
[PVIFA​13%, 10​= 5.426]

PV​B​= 100 (5.426) + 294.6

PV​B​= $837.2 ​[The value of the bond decreases.]

2. What would happen to the bond’s value if inflation fell, and declined to 7

percent? Would we now have a premium or a discount bond?

Premium bond because the present value of the bond is above its par value.

​ FV= $1000 MR= 7% n= 10 yrs CR= 10%

FV
PV​B​= PMT (PVIFA​i, n​) + (1+i)
n [PMT= 1000 × 0.1= $100]
1000
PV​B​= 100 (PVIFA​7%, 10​) + (1+0.07)10
[PVIFA​7%, 10​= 7.0236]

PV​B​= 100 (7.0236) + 508.3

PV​B​= $1210.7 ​ [The value of the bond increases.]

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3. What would happen to the value of the 10-year bond over time if the required

rate of return remained at 13 percent, or if it remained at 7 percent? (Hint: With a

financial calculator, enter PMT, I, FV, and N, and then change (override) N to see

what happens to the PV as the bond approaches maturity.)

Since it is a discount bond, its value [of the 10-year bond] will be increasing over time. It

is if the required rate of return will remain at 13% until it reaches maturity. Meanwhile, the

premium bond the value of the 10-year bond will decrease over time, the required rate of return

will be remaining at 7%, till it reaches maturity.

FV= $1000 MR= 13% n= 10 yrs CR= 10%

FV
PV​B​= PMT (PVIFA​i, n​) + (1+i)
n [PMT= 1000 × 0.1= $100]

1000
PV​B​= 100 (PVIFA​13%, 10​) + (1+0.13)10
[PVIFA​13%, 10​= 5.426]

PV​B​= 100 (5.426) + 294.6

PV​B​= $837.2

FV= $1000 MR= 7% n= 10 yrs CR= 10%

FV
PV​B​= PMT (PVIFA​i, n​) + (1+i)
n [PMT= 1000 × 0.1= $100]

1000
PV​B​= 100 (PVIFA​7%, 10​) + (1+0.07)10
[PVIFA​7%, 10​= 7.0236]

PV​B​= 100 (7.0236) + 508.3

PV​B​= $1210.7
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F. 1. What is the yield to maturity on a 10-year, 9 percent annual coupon, $1000 par

value bond that sells for $887.00? That sells for $ 1134.20? What does the fact that a

bond sells at a discount or at a premium tell you about the relationship between kd

and the bonds coupon rate?

FV= $1000 n= 10 yrs CR= 9% MV= $887.00

YTM= [C= 1000 0.09 =90]

YTM= 0.1074 = 10.74%

FV= $1000 n= 10 yrs CR= 9% MV= $1134.20

YTM= [C= 1000 0.09 =90]

YTM= = 0.0718 = 7.18%

When kd is higher than coupon rate bonds are issued at a discount. And when kd is lower

the the coupon rate, bonds are issued at a premium.

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2. What are the total return, the current yield, and the capital gains yield for the

discount bond? (Assume the bond is held to maturity and the company does not

default on the bond.)

For the 9% coupon, 10-year bond selling at a price of $887 with a YTM of 10.74% based on

no.1f

Current Yield = $90/$887 = 10.15%

Capital gains yield = YTM- Current Yield

= 10. 74% -10.15%

= .59%

Expected total return = Expected current yield + Expected Capital gains yield

Total expected return is the YTM = 10.74%

G. What is interest rate (or price) risk? Which bond has more interest rate risk, an

annual payment 1-year bond or a 10-year bond? Why?

Interest rate (or price) risk: the risk that a bond will lose value as the result of an increase

in interest rates.

Considering the two bonds, the 10 year bond has a higher interest rate risk. This is

because it has a longer term compared to a 1 year bond. The longer the term of the bond

the higher will be its risk for interest rate changes in the market.
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H. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year

bond or a 10-year bond?

Reinvestment rate risk is a kind of risk that a decline in interest rates when bonds

are reinvested will lead to a decline in income from a bond portfolio.

Considering the two bonds, a 1 year bond has a higher reinvestment risk. This is

because every year it will be subjected to the possibility of changes in the interest rate in

the market unlike with a 10 year bond that will be reinvested every ten years.

I. How does the equation for valuing a bond change if semi-annual payments are

made? Find the value of a 10-year, semi-annual payment, 10 percent coupon bond if

nominal kd = 13%.

FV= $1000 MR= 6.5% n= 20 yrs CR= 10%

PVB= PMT (PVIFAi, n) + [PMT= = $50]

PVB= 50 (PVIFA6.5%, 20) + [PVIFA6.5%, 20= 11.032]

PVB= 50 (11.032) + 283.8

PVB= $835.40
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J. Suppose you could buy, for $1000, either a 10 percent, 10-year annual payment

bond or a 10 percent, 10-year semi-annual payment bond. They are equally risky.

Which would you prefer? If $1000 is the proper price for the semi-annual bond,

what is the equilibrium price for the annual payment bond?

SEMI ANNUAL SHOULD BE PREFFERED.

EAR =

-1= [1+0.10/2]^2 -1=10.25%

It is better than 10.0%

The equilibrium price for the annual payment would be $984.80

While the semi-annual bond is 1,000

K. Suppose a 10-year, 10 percent semiannual coupon bond with a par value of $1000 is

currently selling for $1135.90, producing a nominal yield to maturity of 8 percent.

However, the bond can be called after 4 years for a price of $1050.

1. What is the bond’s nominal yield to call (YTC)?

YTC = (50+((1050-1135.90)/8))/( (1050+1135.90)/2)

= 39.27/ 1092.95

= .0359/ 3.59%
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2. If you bought this bond, do you think you would be more likely to earn the

YTM or the YTC? Why?

Considering the the YTC has a lower rate compared to YTM, it would be best to

have it for callback. In this case, the company could save 2% of interest

(10%-8%) since the new issue of bonds is only for 8%.

L. Does the yield to maturity represent the promised or expected return on the bond?

It depends on whether bond holders will call back or hold until maturity the bonds.

If bondholder callback, they would not get the Yield to maturity that will only be earned

onced bonds are held up to maturity. In this case, the yield to maturity will be the

expected return on the bond.

M. These bonds were rated AA- by S&P. Would you consider these bonds investment

grade or junk bonds?

A grade bonds are considered to be investment grade bonds since the A level is the

highest grading that S&P can give to bonds.

N. What factors determine a company’s bond rating?

The factors that determine the bond rating are its Debt equity ratio, profitability ratios,

other relevant financial ratios and size of the firm.

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O. If this firm were to default on the bonds, would the company be immediately

liquidated? Would the bondholders be assured of receiving all of their promised

payments?

In case of default, the company may or may not immediately liquidated depending on the

value of the firm if reorganized. If the value of the firm’s assets are still of great value

until reorganization, it will not be liquidated but streamlining activities to reduce the debt

exposure of the company will be observed. In return, bond holder may not receive their

promised payment. In the case of liquidation, liquidators will follow the payment of debts

based on priority of claims, in case the company assets would not be enough to pay for all

of its debts. The bondholder may not receive all of their promised payments.