FNCE10002 Principles of Finance Semester 2, 2024

Department of Finance
FNCE10002 Principles of Finance
Semester 2, 2024

Debt
Tutorial Questions for Topic 3

Priority questions this week:

A1, A4, B4, C1, C2

A. Short Answer Questions

Provide brief responses to the following questions.

A1. Explain why prices and yields to maturity are inversely related.

A2. What are the similarities and differences between a Treasury note, a promissory note and
a bill of exchange?

A3. Outline the differences between short- and long-term debt instruments. [note that the
name relates to the term to maturity at the time of issuance rather than the remaining
term to maturity].

A4. How does a “green” bond differ to a standard bond? How would the approach to pricing a
green bond be different to a standard bond?

B. Multiple Choice Questions

For each question pick the most reasonable response based on the information provided.

Questions B1 – B3 are based on the following information.

Consider the following two corporate bonds where the coupon is paid annually and there is
exactly one year until the next coupon is received.

Price per $100

Bond Coupon Rate Time to Maturity Face Value
A 8.0% 1 year $93.91

Tutorial Questions for Topic 3 1

FNCE10002 Principles of Finance Semester 2, 2024

B 12.0% 15 years $82.46

B1. The yield to maturity of Bond A is closest to:

a) 6.5%
b) 8.0%
c) 12.0%
d) 15.0%

B2. The yield to maturity of Bond B is closest to:

a) 10.0%
b) 12.0%
c) 15.0%
d) 16.0%

B3. Elroy Investors is interested in purchasing the bonds of the Judy Company which have a
face value of $1,000. Judy’s bonds are currently priced at $1100.00 and have 14 years to
maturity. If the bonds have a 6% coupon rate, which of the following is closest to the
yield to maturity of these annual coupon paying bonds?

a) 6.00%
b) 5.1%
c) 4.99%
d) 2.5%

B4. Consider the following details for a bond issued by Bravo Incorporated.

Issue date 8 Mar 2020

Maturity date 8 Mar 2050
Coupon rate (annual coupons) 9%
Face value $1000

If today’s date is 8 Mar 2024 and a coupon has just been paid, what should the current
trading price be for this bond if investors want a 12% annual return from the bond?

a) $658.09
b) $763.12
c) $908.88
d) $1000.00

C. Problems

C1. Jack and Jill Trzetrzelewska wish to purchase a new home costing $200,000 and they
plan to have a 20% deposit for the property. First Australia Bank (FAB) will lend them
the required funds at a fixed interest rate of 9% per annum (compounding monthly) for a
25-year period, with monthly payments to begin in one month’s time. Assume end-of-the-
month cash flows.

Tutorial Questions for Topic 3 2

FNCE10002 Principles of Finance Semester 2, 2024

a) Compute the monthly payments that Jack and Jill will make on their home loan.

b) Develop an amortization schedule for the loan for months 1 through 4 and obtain
the following information from this schedule.

(i) The total amount owed at the end of month 4.

(ii) The total interest paid in month 2 (i.e. the interest component of the
second payment).
(iii) The total principal repaid in month 3 (i.e. the principal component of the
third payment).

c) Suppose it is now the end of year 10 (that is, 120 months have elapsed since the
funds were first borrowed) and Jack and Jill have decided to repay the amount
outstanding in full. What amount do they now need to pay the bank? Assume that
Jack and Jill have been making regular monthly payments over the past 10 years.

d) What is the current effective annual rate on the loan?

C2. Suppose ABC Ltd needs funds for 180 days only and decides to raise the money by
discounting a bank bill. ABC Ltd immediately draws a 180-day bill for $500,000 and this
is sold into the market to yield 9.58%.

What are the proceeds from discounting the bill?

D. Closing the loop with Desmos interactive graphs

This week we are going to use a Desmos interactive graph to check our answers to problem C1.

Open the Desmos graph at the following address: https://go.unimelb.edu.au/92hs

Use the graph to check your answers to C1 (a), (b) and (c). Remember that you can change the
scale of the axes by selecting the spanner icon on the right-hand side of the graph.

Tutorial Questions for Topic 3 3

FNCE10002 Principles of Finance Semester 2, 2024

A. Short Answer Questions

A1. Refer to examples in lecture slides. As yields rise, the price of the bond falls to reflect the
impact of discounting at a higher rate.

A2. Similarities: all are short-term, promise one future cash flow (the face value) on the
maturity date and are priced using simple interest.
Differences: Treasury notes are issued by the government, Promissory notes are issued
by private entities and Bills of exchange are a guarantee of repayment by a bank if the
borrower is unable to pay.

A3. Generally, short-term debt is repayable in less than 12 months with repayment of the face
value of the security on the maturity date and priced using simple interest. Generally,
long-term debt is repayable (ie “matures”) in more than 12 months, with periodic
payment of interest accrued and is priced using compound interest.

A4. A green bond refers to a bond where the proceeds raised are committed to projects that
have a positive environmental impact. While the approach to pricing “green” bonds is
exactly the same as standard bonds (i.e. coupons and the face value are discounted at the
market yield to maturity), there is some evidence that “green bonds” trade at a slightly
higher price (lower yield) than comparable standard bonds. This is what’s often referred
to as the “greenium”.

B. Multiple Choice Questions

B1. D is correct. The yield to maturity (kd) can be computed as:

B2. C is correct. Because the bond is selling at a discount, its yield to maturity must be greater
than the coupon rate of 12%. So, the only two possible answers are 15% and 16%.

Substituting in 15% for kd, we get:

So, the yield to maturity is 15.0% pa.

B3. C is correct
1100 = [60/i][1 - 1/ (1 + i)14]} + 1000/(1 + i)14
i = 4.99%

B4. B is correct

Suggested Answers to Tutorial Questions for Topic 3 1

FNCE10002 Principles of Finance Semester 2, 2024

PV = [90/0.12][1 - 1/ (1.12)26]} + 1000/(1.12)26

PV = $763.13

C. Problems

C1. a) Amount borrowed = 200000 – 0.2(200000) = $160,000.

Effective monthly interest rate = 9/12 = 0.75%.
Total number of months = 25  12 = 300.

Amount borrowed = Monthly payment  [1 – (1 + 0.0075)-300] /0.0075.

160000 = Monthly payment  [119.1616].
Monthly payment = 160000/119.1616 = $1,342.71.

b) Interest paid in month 1 = 0.0075  160000 = $1,200.

Principal repaid in month 1 = 1342.71 – 1200 = $142.71.
Principal balance at the end of month 1 = 160000 – 142.71 = $159,857.29.

The loan’s amortization schedule for the first 4 months is as follows:

Monthly Principal
Monthly Interest Repaid Princip4al
Month Payment (3) = (5)-1  (4) = (2) – Remaining
(1) (2) 0.75% (3) (5) = (5)-1 – (4)
0 – – – $160,000.00
1 $1,342.71 $1,200.00 $142.71 $159,857.29
2 $1,342.71 $1,198.93 $143.78 $159,713.50
3 $1,342.71 $1,197.85 $144.86 $159,568.64
4 $1,342.71 $1,196.76 $145.95 $159,422.69

(i) The total amount owed at the end of month 4 = $159,422.69.

(ii) The total interest paid in month 2 = $1,198.93.
(iii) The total principal repaid in month 3 = $144.86.

c) Remaining term of the loan = 300 – 120 = 180 months.

Loan amount outstanding = Monthly payment  [1 – (1 + 0.0075)-180/0.0075].
Loan amount outstanding = 1342.71[98.5934] = $132,382.36.

d) re = (1 + r/m)m – 1 = (1 + 0.09/12)12 – 1 = 9.38% p.a.

C2. Proceeds from discounting the bill = FV/[1 + r(n/365)] = $477,443.73

Where r = 0.0958 and n = 180

Suggested Answers to Tutorial Questions for Topic 3 2