EBW 1063 Managerial Finance

Tutorial 3: Bonds and Their Valuation

1. Bond valuation Callaghan Motors’ bonds have 10 years remaining to maturity. Interest is
paid annually; they have a $1,000 par value; the coupon interest rate is 8 percent; and the yield to
maturity is 9 percent. What is the bond’s current market price?

N = 10; YTM = rd = 9%; PMT = 0.08 x 1,000 = 80; FV = 1000; PV = VB =?

[ ( )] [
1

PV = PMT
1−
( 1+rd )N +
rd
FV
( 1+rd )N ]

[( )] [
1

¿ 80
1−
(1.09 )10 +
0.09
1000
( 1.09 )10 ]
= 80 (6.4176) + 422.41

= 513.41 + 422.41

= $ 935.82

Another method:

Bond’s current market price, VB

¿∑
N
∫ ¿ + M ¿= [ 80 +
1
t=1 (1+rd )
t
(1+ rd)
N
(1.09)
80 80 80 80 80 80 80 80 80
2
+ 3
+ 4
+ 5
+ 6
+ 7
+ 8
+ 9
+ 10 ] +
(1.09) (1.09) (1.09) (1.09) (1.09) (1.09) (1.09) (1.09) (1.09)
1000
10
(1.09)

= [73.39 + 67.33+ 61.77+ 56.67 + 51.99 + 47.70 + 43.76 + 40.15 + 36.83 + 33.79] + 422.41

= 513.38 + 422.41

= $ 935.79

(better using 4 decimal place in calculation)

2. Bond valuation Nungesser Corporation’s outstanding bonds have a $1,000 par value, a 9
percent semiannual coupon, 8 years to maturity, and an 8.5 percent YTM. What is the bond’s
price?

N = 2 x 8 = 16; YTM = rd = 8.5/2 = 4.25; PMT = 45; FV = 1000

[ ( )] [
1

PV = PMT
1−
( 1+rd )N +
rd
FV
( 1+rd )N ]

[( )] [
1

¿ 45
1−
( 1.0425 )16 +
0.0425
1000
( 1.0425 )16 ]
= 45 (11.4403) + 513.79

= 514.81 + 513.79

= $ 1,028.60

Another method:

Bond’s price, VB
∫¿
2N
2 M
¿∑ t
+ 2N
¿
t=1 rd rd
(1+ ) (1+ )
2 2

3. Bond valuation An investor has two bonds in his portfolio that both have a face value of
$1,000 and pay a 10 percent annual coupon. Bond L matures in 15 years, while Bond S matures
in 1 year.

What will the value of each bond be if the going interest rate is 5 percent, 8 percent, and 12
percent? Assume that there is only one more interest payment to be made on Bond S, at its
maturity, and 15 more payments on Bond L.

i. 5%
Bond L: N = 15; I/YR = 5; PMT = 100; FV = 1000; PV?
 [ ( )] [
1

PV = PMT
1−
( 1+rd )N +
rd
FV
( 1+rd )N ]

[ ( )] [
1

Bond L= 100
1−
(1.05 )15 +
0.05
1000
( 1.05 )15 ]
= 1037.97 + 481.02

= $1,518.98

Bond S: change N = 1, PV?

[ ( )] [
1

Bond S= 100
1−
( 1.05 )1 +
0.05
1000
( 1.05 )1 ]
= 95.24 + 952.38

= $1,047.62

ii. 8%

[( )] [
1

Bond L= 100
1−
(1.08 )15 +
0.08
1000
( 1.08 )15 ]
= 855.9478 + 315.2417

= $ 1,171.19

[ ( )] [
1

Bond S= 100
1−
( 1.08 )1 +
0.08
1000
( 1.08 )1 ]
= 92.5925 + 925.9259

= $1,018.52

iii. 12%

[( )] [
1

Bond L= 100
1−
(1.12 )15 +
0.12
1000
( 1.12 )15 ]
 = 681.0864 + 182.6962

= $863.78

[ ( )] [
1

Bond S= 100
1−
( 1.12 )1 +
0.12
1000
( 1.12 )1 ]
= 89.2857 + 892.8571

= $982.14

4. Interest rate sensitivity An investor purchased the following 5 bonds. Each of them had an 8
percent yield to maturity on the purchase day. Immediately after she purchased them, interest
rates fell and each then had a new YTM of 7 percent. What is the percentage change in price for
each bond after the decline in interest rates? Fill in the following table:

Old YTM = 8%; new YTM = 7%;

Price @ Price @ Percentage

8% 7% change
10-year, 10% annual coupon $1,134.20 $1,210.71 6.75%
10-year zero 463.19 508.35 9.75
5-year zero 680.58 712.99 4.76
30-year zero 99.38 131.37 32.19
$100 perpetuity 1250.00 1,428.57 14.29

Calculation for 10-year, 10% annual coupon Calculation for 10-year zero; 5-year zero; 30-

[ ( )] [
1 year zero

PV = PMT
1−
( 1+rd )N +
rd
FV
( 1+rd )N ] PV =
par value
( 1+r d )
N

When YTM = 8% with 10-year zero;

When YTM = 8%; 1000

[( )] [
1 = 10

]
1− 1000 (1+0.08)
( 1+0.08 )10 + = $463.19
¿ 100 ( 1+0.08 )10
0.08
= 671.01 + 463.19
= $1,134.20
Calculation for $100 perpetuity Calculation for percentage change
PMT Percentage change =
perpetuity=
I price at 7 %− price at 8 %
When YTM = 8%; price at 8 %
100 When 10-year, 10% annual coupon;
= $ 1,210.71−$ 1,134.20
0.08
=
= $1,250 $ 1,134.20
= 0.0675 or 6.75%

5. Yield to call Six years ago, the Singleton Company issued 20-year bonds with a 14 percent
annual coupon rate at their $1,000 par value. The bonds had a 9 percent call premium, with 5
years of call protection. Today, Singleton called the bonds. Compute the realized rate of return
for an investor who purchased the bonds when they were issued and held them until they were
called. Explain why the investor should or should not be happy that Singleton called them.

N = 6; PMT = 0.14 x 1000 = 140; PV = 1000; FV = 1000 + (1000×0.09) = 1090

[ ( )] [
1

PV = PMT
1−
( 1+rd )N +
rd
FV
( 1+rd )N ]
Trial and error method:

Since PV< FV = (1000 < 1090)  rd > coupon rate;

So, test for 15% & 16% when coupon rate is 14%;

1
1− 6
1090
rd:15%, PV = [140 ( (1+0.15) )] + [ 6]
(1+0.15)
0.15

= 529.83 + 471.24

= $1,001.07

1
1− 6
1090
rd:16%, PV = [140 ( (1+0.16) )] + [ 6]
(1+0.16)
0.16

= 515.86 +447.38

= $963.24

When PV = $1000 (rd is in between 15% & 16%);

YTC −15 % 1000−1001.07

=
16 %−15 % 963.24−1001.07
YTC−15 % −1.07
=
1% −37.83

YTC-15% = 0.02828 (1% or 0.01)

YTC = 15 + 0.02828

= 15.03%

Despite a 15% return on the bonds, investors are not likely to be happy that they were called.
Because if the bonds haven been called, this indicates that interest rates haven fallen sufficiently
that the YTC is less than the YTM. (Since they were originally sold at par, the YTM at issuance
= 14%). Rates are sufficiently low to justify the call. Now investors must reinvest their funds in a
much lower interest rate environment.

6. Current yield A semiannual coupon bond that matures in 7 years sell for $1,020. It has a face
value of $1,000 and a yield to maturity of 10.5883 percent. What is its current yield?

N = 14; YTM = 10.5883/2 = 5.29415%; FV = 1000; PV = 1020; PMT=?

[ ( )] [
1
1−
PV = PMT
( 1+rd )N
rd
+
FV
( 1+rd )N ]
( )
1
PV -
[
FV
( 1+rd ) N =
PMT
1−
]
(1+rd ) N
rd

PMT =
PV −
[ FV
( 1+ rd ) N ]
( )
1
1−
( 1+rd )N
rd

¿
1020−
(( 1000
1.0529415 )
14
)
( )
1
1−
( 1.0529415 )14
0.0529145

534.33
¿
9.715

=$55.00 ----- semi annual

Annual interest = $55 x 2 = $110

annual interest $ 110

Current yield= = = 10.78%
current price $ 1020