Bond valuation

Assume you make the following investments: •A $10,000 investment in a 10-year Treasury bond that yields 11.5% •A $20,000 investment in a 10-year corporate bond with an AA rating and a yield of 15.0%

15.0-11.5

Suppose the real risk-free rate and inflation rate are expected to remain at their current levels throughout the foreseeable future. Consider all factors that affect the yield curve. Then identify which of the following shapes that the U.S. Treasury yield curve can take.

Upward-sloping yield curve (MRP = 0), the U.S. Treasury yield curve will be flat. If the maturity risk premium is positive, the U.S. Treasury yield curve is upward sloping. The yield curve cannot be downward sloping or inverted, because the maturity risk premium cannot decrease with maturity.

When the bond's coupon rate is greater than the bondholder's required return, the bond's intrinsic value will __ its par value, and the bond will trade at a premium. When the bond's coupon rate is less than the bondholder's required return, the bond's intrinsic value will be less than its par value, and the bond will trade at__

exceed, a discount

7. Valuing semiannual coupon bonds Bonds often pay a coupon twice a year. For the valuation of bonds that make semiannual payments, the number of periods doubles, whereas the amount of cash flow decreases by half. Using the values of cash flows and number of periods, the valuation model is adjusted accordingly. Assume that a $1,000,000 par value, semiannual coupon U.S. Treasury note with four years to maturity has a coupon rate of 3%. The yield to maturity (YTM) of the bond is 9.90%. Using this information and ignoring the other costs involved, the value of the Treasury note is $___

(3% x $1,000,000)/2 = $15,000.00 9.90%/2 = 4.9500%. 4 years*2= 8 p/y, N, I, FV, PMT, = PV? 2, 8, 9.90, 1,000,000, 15000 =-776,567.78 The Treasury note pays a semiannual coupon payment, so the YTM will need to be adjusted. Rather than a four-year bond, think of this as an eight-year bond that makes annual interest payments at half the coupon rate. The Treasury note makes 8 payments of $15,000.00 [(3% x $1,000,000)/2 = $15,000.00]. The YTM used for discounting the cash flows will be 9.90%/2 = 4.9500%.

8. Bond yields 1)Coupon payments are fixed, but the percentage return that investors receive varies based on market conditions. This percentage return is referred to as the bond's yield. A bond's yield to maturity (YTM) refers to the rate of return expected from a bond held until its maturity date. However, the YTM equals an investor's expected rate of return under certain assumptions. Which of the following is one of those assumptions? The bond is callable. The probability of default is zero. 2)Consider the case of Black Sheep Broadcasting Company: Black Sheep Broadcasting Company has 9% annual coupon bonds that are callable and have 18 years left until maturity. The bonds have a par value of $1,000, and their current market price is $1,010.35. However, Black Sheep may call the bonds in eight years at a call price of $1,060. What are the YTM and the yield to call (YTC) on Black Sheep's bonds? Value YTM __ YTC ___ The current yield on the bond is ___ 3) If interest rates are expected to remain constant, what is the best estimate of the remaining life left for Black Sheep's bonds? 10 years 18 years 5 yearsIf interest rates are expected to remain constant, what is the best estimate of the remaining life left for Black Sheep's bonds? 10 years 18 years 5 years 13 years 13 years

1. 2. N=18 FV=1,000 PV=1010.35 PMT=90 I/YR=? ytm=8.88 YTC (Bond Yield to Call) Ytc = ( I + ( ( Pc - Pm ) / N ) ) / ( ( Pc + Pm ) / 2 )×100 Where, Pc = Call Price =1060 Pm = Market Price 1010.35 I = Annual Interest =90 N = Number of Years Until Call=8 YTC=9.35% (90/1010.35)*100=8.90% 3. 18yrs The YTC is greater than the YTM on Hungry Whale's bonds. YTC 9.35% > YTM 8.88% If interest rates remain constant, the firm will not call the bonds. The bonds will be held until maturity, so their expected remaining life is 18 years.

Now, consider the situation in which Liam wants to earn a return of 15%, but the bond being considered for purchase offers a coupon rate of 12.00%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of ----(rounded to the nearest whole dollar) is--- its par value, so that the bond is---.

15%/2=7.5 [($1,000 x 0.12)/2]=60 12.00% coupon rate n=6 i=7.5 fv=1,000 pmt=60 pv=?, =-930 $930 <$1000 par value, Trading at a discount $1000+> PV Trading at a premium

11. Bond ratings Rating agencies—such as Standard & Poor's Corporation (S&P), Moody's Investor Service, and Fitch Ratings—assign credit ratings to bonds based on both quantitative and qualitative factors. These ratings are considered indicators of the issuer's default risk, which impacts the bond's interest rate and the issuer's cost of debt capital. Based on these ratings, bonds are classified into investment-grade bonds and junk bonds. Which of the following bonds is likely to be classified as an investment-grade bond? A bond whose issuer has a 10% return on capital, a total debt to total capital ratio of 85%, and a 13% yield. A bond whose issuer has a 30% return on capital, a total debt to total capital ratio of 15%, and a 6% yield. You heard that rating agencies have downgraded a bond's rating. The yield on the bond is likely to__ , and the bond's price will __ .

A bond whose issuer has a 30% return on capital, a total debt to total capital ratio of 15%, and a 6% yield If they DOWNGRADED the ratings from, say, a rating of A to BBB, the bond's yield will increase. Because their risk exposure increases, an investor will expect a higher return, thus pushing up the security's yield, and causing the price of the bond to drop. Similarly, if a bond is UPGRADED, ratings would indicate a decrease in the chances of the firm defaulting on its payments toward the bond. Because their risk exposure decreases, investors will be willing to settle for a lower yield, which will increase the price of the bond.

Given your computation and conclusions, which of the following statements is true? A. When the coupon rate is greater than Liam's required return, the bond should trade at a premium. B. When the coupon rate is greater than Liam's required return, the bond should trade at a discount. X C. A bond should trade at par when the coupon rate is greater than Liam's required return. D. When the coupon rate is greater than Liam's required return, the bond's intrinsic value will be less than its par value. X

A. When the coupon rate is greater than Liam's required return, the bond should trade at a premium.

6. Bond yields and prices over time A bond investor is analyzing the following annual coupon bonds: Issuing Company Annual Coupon Rate Johnson Enterprises 6% Smith Incorporated 12% Irwin Metalworks 9% Each bond has 10 years until maturity and has the same risk. Their yield to maturity (YTM) is 9%. Interest rates are assumed to remain constant over the next 10 years. Label the curves on the following graph to indicate the path that each bond's price, or value, is expected to follow.

Bond value ($) YTM is 9% which one leads? last? Johnson Enterprises 6% Smith Incorporated 12% Irwin Metalworks 9% hint: Smith lead

For example, assume Liam wants to earn a return of 10.50% and is offered the opportunity to purchase a $1,000 par value bond that pays a 12.00% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value: Unknown Variable Name Variable Value A -- __ B -- $1,000 C Semiannual required return __

Bond's semiannual coupon payment $60.00 Bond's par value 5.25% [($1,000 x 0.12)/2]=60 10.50/2=5.25

9. Determinants of market interest rates Some characteristics of the determinants of nominal interest rates are listed as follows. Identify the components (determinants) and the symbols associated with each characteristic: Characteristic Component It changes over time, depending on the expected rate of return on productive assets exchanged among market participants and people's time preferences for consumption. This is the rate for a riskless security that is exposed to changes in inflation. This is the premium added to the real risk-free rate to compensate for a decrease in purchasing power over time. This is the premium added as a compensation for the risk that an investor will not get paid in full. This premium is added when a security lacks marketability, because it cannot be bought and sold quickly without losing value. As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty.

Real risk-free rate Nominal risk-free rate Inflation premium Default risk premium Liquidity risk premium Maturity risk premium

If interest rates are expected to remain constant, what is the best estimate of the remaining life left for Black Sheep's bonds? 10 years 18 years 5 years 13 years If Black Sheep Broadcasting Company issued new bonds today, what coupon rate must the bonds have to be issued at par? 8.24% 6.84% 8.88% 8.32%

The YTC is greater than the YTM on Hungry Whale's bonds. If interest rates remain constant, the firm will not call the bonds. The bonds will be held until maturity, so their expected remaining life is 18 years. The YTM on Hungry Whale's existing bonds reflects the rate of return that investors require for holding debt securities issued by Hungry Whale Seacraft Company. If Hungry Whale is to issue new bonds at par, the new bonds must pay a coupon equal to their current YTM.

What will happen to the price of a fixed-rate bond when expectations for inflation FALL? The bond price will fall. The bond price will rise.

The going interest rate in the market is influenced by various factors, including inflation. If expectations for inflation RISE, the going interest rate or the yield required by the market also will RISE. If a bond is a fixed-rate bond, the interest (coupon) on the bond will not change. Thus, the yield on the bond will be less than the yield required by the market, leading to a LOWER bond price. Likewise, if expectations for inflation FALL, the going interest rate or the yield required by the market also will FALL. If a bond is a fixed-rate bond, the interest (coupon) on the bond will not change. Thus, the yield on the bond will be more than the yield required by the market, leading to a HIGHER bond price. The bond price will RISE.

Which of the following statements is true about a Chapter 7 liquidation? Secured creditors are behind preferred shareholders in the priority of claims. Customers will get all their deposit money back before any monies are paid to unsecured creditors. In the priority of claims, state taxes are ahead of general creditors. Common stockholders typically receive monies during a liquidation.

The priority of claims in Chapter 7 liquidation are as follows: 1) past-due property taxes; 2) secured creditors entitled to the proceeds from the sale of collateral; 3) trustee costs for administering the bankruptcy; 4) expenses incurred after the bankruptcy was filed; 5) wages due workers, capped at a maximum amount per worker and limited to wages earned within a specified period prior to the bankruptcy; 6) claims for unpaid contributions to employee benefit plans, capped at a maximum amount per worker and limited to wages earned within a specified period prior to the bankruptcy; 7) unsecured claims for customer deposits, capped at a maximum amount per customer; 8) federal, state and local taxes due; 9) unfunded pension plan liabilities, although some limitations exist; 10) general unsecured creditors; 11) preferred stockholders, up to the par value of their stock; 12) common stockholders. It is unusual for anything to be left to pay the common stockholders.

8. Bond yields Coupon payments are fixed, but the percentage return that investors receive varies based on market conditions. This percentage return is referred to as the bond's yield. A bond's yield to maturity (YTM) refers to the rate of return expected from a bond held until its maturity date. However, the YTM equals an investor's expected rate of return under certain assumptions. Which of the following is one of those assumptions? The bond is callable. The probability of default is zero. Consider the case of Black Sheep Broadcasting Company: Black Sheep Broadcasting Company has 9% annual coupon bonds that are callable and have 18 years left until maturity. The bonds have a par value of $1,000, and their current market price is $1,010.35. However, Black Sheep may call the bonds in eight years at a call price of $1,060. What are the YTM and the yield to call (YTC) on Black Sheep's bonds? Value YTM__ YTC__ The current yield on the bond is __

The probability of default is zero. The bond will not be called. N18 FV1000 PV1010.35 PMT90 I/YR? ytm= 8.88% Yield To Call = ( I + ( ( Pc - Pm ) / N ) ) / ( ( Pc + Pm ) / 2 )×100 Where, Pc = Call Price 1060 Pm = Market Price 1010.35 I = Annual Interest 90 N = Number of Years Until Call 8 ytc= 9.35% (90/1010.35)*100=8.91 The current yield on the bond is 8.91%

5. Bond evaluation Remember, a bond's coupon rate partially determines the interest-based return that a bond ___ pay, and a bondholder's required return reflects the return that a bondholder____ to receive from a given investment.

Will, Would like

Assuming that interest rates remain constant, the T-note's price is expected to --increase .•The T-note described is selling at a--discount .•When valuing a semiannual coupon bond, the time period variable (N) used to calculate the price of a bond reflects the number of--6-month periods remaining in the bond's life.

increase, discount, 6-month The market price of the Treasury bonds is $776,567.78. Because the price is below the par value, the bond is selling at a discount. If rates remain constant, the bond's price will appreciate (increase) gradually over time until it equals the face value of $1,000,000 at maturity. The value of a bond is the sum of the present values of its expected future cash flows. When calculating the value of a bond, the time period variable (N) represents the number of six-month—rather than annual—periods remaining in the bond's life.

James bought shares of a heavily traded stock listed on the New York Stock Exchange (NYSE), whereas Victoria bought stocks of a rural bank with a very small number of shareholders. Whose investment is more exposed to marketability risk? Victoria's investment James's investment

rural bank would not be able to cover your lost.

Based on this equation and the data, it is -- to expect that Liam's potential bond investment is currently exhibiting an intrinsic value less than $1,000.

unreasonable