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Review Problems#3
Question-1

Mark Goldsmith's broker has shown him two bonds. Each has a maturity of 5 years, a par value of
$1,000, and a yield to maturity of 12%. Bond A has a coupon interest rate of 6% paid annually.
Bond B has a coupon interest rate of 14% paid annually.

a. Calculate the selling price for each of the bonds.

ANSWER:
 (1  r ) N  1   1   (1  0.12)5  1   1 
BA  C   N 
 FV   N 
 60   5
 1, 000   5
 783.71
 r  (1  r )   (1  r )   0.12  (1  0.12)   (1  0.12) 

 (1  r ) N  1   1   (1  0.12)5  1   1 
BB  C   N 
 FV   N 
 140   5
 1, 000   5
 1072.10
 r  (1  r )   (1  r )   0.12  (1  0.12)   (1  0.12) 

b. Mark has $20,000 to invest. Judging on the basis of the price of the bonds, how many of either
one could Mark purchase if he were to choose it over the other? (Mark cannot really purchase
a fraction of a bond, but for purposes of this question, pretend that he can.)

ANSWER:

Mark can buy 20,000/783.71=25.52 Bond A and 20,000/1072.10=18.66 Bond B

c. Calculate the yearly interest income of each bond on the basis of its coupon rate and the
number of bonds that Mark could buy with his $20,000.

ANSWER:
Annul Interest Income from Investment in Bond A: 25.52 x 60 =$1,531.17
Annul Interest Income from Investment in Bond B: 18.66 x 140 =$2,611.71

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d. Assume that Mark will reinvest the interest payments as they are paid (at the end of each year)
and that his rate of return on the reinvestment is only 10%. For each bond, calculate the value
of the principal payment plus the value of Mark's reinvestment account at the end of the 5
years. What is the compound average growth rate (CAGR) of Mark’s investment for each
bond investment?

T Reinvestment Account
Bond-A Reinvestment Account
1 60.00 87.85
2 60.00 79.86
3 60.00 72.60
4 60.00 66.00
5 60.00 60.00
FV 1000.00 1000.00

Total 1,366.31

T Reinvestment Account
Bond-A Reinvestment Account
1 140 204.97
2 140 186.34
3 140 169.4
4 140 154
5 140 140
FV 1000 1000

Total 1,854.71

Based on the final amounts accumulated, Compound Average Growth Rate for investments A and
B are the following:

Investment A: Initial investment: $783.71 Accumulated future value as of year 5 =1,366.31

CAGR=(1366.21/783.71)(1/5)-1=11.77%

Investment A: Initial investment: $783.71 Accumulated future value as of year 5 =1,366.31

CAGR=(1871.54/1072.10)(1/5)-1=11.79%
CAGR is also referred to as Geometric Average Return.

An alternative way to calculate the realized return on bond investment is to use internal rate of
return with a modification. Internal Rate of Return of a bond is the rate that equates the bond price
to the present value of its cash flows.
60 60 60 60 60  1, 000
783.71     
(1  IRR) (1  IRR) 2 (1  IRR)3 (1  IRR) 4 (1  IRR)5

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The IRR of the bond is equal to Yield to Maturity. The IRR that satisfies the above equation is 12%,
which is the YTM of the bond. The underlying assumption in IRR or YTM is that each coupon
received is reinvested to earn the IRR or YTM. In our example, we are told that received coupons
will be reinvested at 10% rather than at YTM or 12%. To calculate the realized return with this
assumption we can use the method we used above. In excel function MIRR help us to calculate the
realized return under the assumption that coupon interest is reinvested at 10% rate1.

($783.71)
60
60
60
60
1060

MIRR 11.76%

The inputs for MIRR function are the range of cash flows (i.e. bond price, coupon payments and
the principal at the maturity), an arbitrary rate of return (5% inputed above to start the algorithm),
and reinvestment rate.
N 5

C t  (1  k )t  FV  60  (1  0.1) t
 1, 000
P0  t 1
 783.71  t 1

(1  MIRR) (1  MIRR)
Solving the above equation for MIRR is equivalent to calculation of CAGR or Geometric Average
Return.

e. Why are the two values calculated in part d different? If Mark were worried that he would earn
less than the 12% yield to maturity on the reinvested interest payments, which of these two bonds
would be a better choice?

The absolute amounts accumulated are different simply because Bond B pays higher interest than
Bond B. The realized Compound Average Growth Rates or Geometric Average Returns are

1
In generic terms, whenever cash inflows are re- insvested to earn a rate other than IRR, we can use MIRR
to calculate the realized return.

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different because reinvestment rate is defined as 10% rather than 12%. If reinvestment rate were
12%, CAGR would be 12%. If Mark were worried that he would earn less than 10% return on
reinvested coupons, Bond B offers a better alternative as it yields higher than Bond A.

Question-2

Pecos Manufacturing has just issued a 15-year, 12% coupon interest rate, $1,000-par bond that
pays interest annually. The required return is currently 14%, and the company is certain it will
remain at 14% until the bond matures in 15 years.

a. Assuming that the required return does remain at 14% until maturity, find the value of the
bond with (1) 15 years, (2) 12 years, (3) 9 years, (4) 6 years, (5) 3 years, and (6) 1 year to
maturity.

Bond N BondValue Excel Formula

Coupon Interest 12%
YTM 14% 1 982.46 @PV(0.14,1,-120,-1,000)
Face Value 1000 3 953.57 @PV(0.14,3,-120,-1,000)
N 12 6 922.23 @PV(0.14,6,-120,-1,000)
Bond Price $886.79 9 901.07 @PV(0.14,9,-120,-1,000)
12 886.79 @PV(0.14,12,-120,-1,000)
15 877.16 @PV(0.14,15,-120,-1,000)

b. Plot your findings on a set of "time to maturity (x axis)-market value of bond (y axis)" axes.

Bond Price
990.00
970.00
950.00
930.00
910.00
890.00
870.00
850.00
1 3 6 9 12 15
Time to Maturity

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c. All else remaining the same, when the required return differs from the coupon interest rate and
is assumed to be constant to maturity, what happens to the bond value as time moves toward
maturity? Explain in light of the graph in part b.

When the required rate of return differs from the coupon rate, and it remains constant duriing the
life of the bond, bond price approaches to its par value. Note that in this particular case, the bond
is a discount bond, at its value increases as the maturity gets closer. A premium bond would have a
price above the par, and it would gradually decline to the par value.

Question-3:

Meyer Inc. outstanding bonds have a $1,000 par value, and they mature in 15 years. Their bond
equivalent yield is 8%, they pay interest quarterly, and they sell at a price of $850. What is the
bond's nominal (annual) coupon interest rate?

ANSWER:

The first order task here is to determine the quarterly discount factor to price the bond. Since the
BEY is 8%, we can quickly calculate periodic discount rate by using the following equation:

m 2 4 2
 r  b  r   0.08 
1    1    1    1  
 m  2  4  2 

2/ 4
 r   0.08 
   1    1  0.0198
4  2 
C/4 C/4 C/4 C / 4  1, 000
850     ....... 
(1  0.0198) (1  0.0198) 2
(1  0.0198) 3
(1  0.0198)60

Solving it for C produces 62. We can use excel function PMT to find the quarterly coupon C/4.
@PMT(0.0198, 60,-850,1,000)=15.51 . Annual coupon is 15.51 x 4 =62

Question-4:

A 20-year, $1,000 par value bond has an 5% annual coupon. The bond currently sells for $875.

a. What is the bond equivalent yield?

50 50 50 50  1, 000
875     ....... 
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) 20

Solving for r yields r=6.1%

m 2 1 2
 r  b  0.061   BEY 
1    1    1    1  
 m  2  1   2 
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 r
m/2

BEY  1    1  2  BEY  [(1  0.061)1/ 2  1]  2  6.01%
 m  

b. If the yield to maturity remains at its current rate, what will the price be 5 years from now?

Five years from now, time to maturity will shrink to 15 years. Bond price then will be
50 50 50 50  1, 000
P    .......   894
(1  0.061) (1  0.061) 2
(1  0.061) 3
(1  0.061)15
Question-5:

Matrix Corp Class B bonds have a 10-year maturity, $1,000 par value, and a 6% coupon paid
semiannually. These bonds are currently traded at their par value. Matrix’s Class A bonds have the
same risk, maturity, and par value, but the Class A bonds pay a 4 % annual coupon. What should
be the price of “A” bonds in the market?

ANSWER:

Since the class B bond is selling at par, semiannual discount factor should be 3%.
30 50 30 30  1, 000
P    .......   1, 000
(1  r / 2) (1  r / 2) 2
(1  r / 2) 3
(1  r / 2)15

Solving it for (r/2 ) suggest that the periodic discount rate is 3%. Since the periodic discount rate
with semiannual compounding is 3%, BEY=6%
2 2
 r   b
1    1    b  6%
 2  2

If BEY is 6%, discount rate with annual compounding should be

2
 0.06 
1  r   1    r  6.09%
 2 
r= (1+0.06/2)^2-1=6.09%

Bond A Bond B
FV 1000 1000
Coupon 6% 4%
N 10 10
YTM 3% 6.09%
Frequency 2 1
Price 1000 $846.83

40 40 40 40  1, 000
P    .......   846.83
(1  0.0609) (1  0.0609) 2
(1  0.0609)3
(1  0.0609)10