CP

An investor has two bonds in his portfolio. Each bond matures in 4 years, has a face value of

$1,000, and has a yield to maturity equal to 9.6 percent. One bond, Bond C, pays an annual

coupon of 10 percent, the other bond, Bond Z, is a zero coupon bond.

a.Assuming that the yield to maturity of each bond remains at 9.6 percent over the next 4

years, what will be the price of each of the bonds at the following time periods? Fill in the

following table:

t Price of Bond C Price of Bond Z

0

1

2

3

4

b.Plot the time path of the prices for each of the two bonds.

Spreadsheet Problem

Start with the partial model in the file Ch 04 P16 Build a Model.xlsfrom the textbook’s web

site. Rework Problem 4-9. After completing parts a through d, answer the following related

questions.

e.How would the price of the bond be affected by changing interest rates? (Hint: Conduct a

sensitivity analysis of price to changes in the yield to maturity, which is also the going mar-

ket interest rate for the bond. Assume that the bond will be called if and only if the going rate

of interest falls below the coupon rate. That is an oversimplification, but assume it anyway for

purposes of this problem.)

f.Now assume that the date is 10/25/2002. Assume further that our 12 percent, 10-year bond

was issued on 7/1/2002, is callable on 7/1/2006 at $1,060, will mature on 6/30/2012, pays in-

terest semiannually (January 1 and July 1), and sells for $1,100. Use your spreadsheet to find

(1) the bond’s yield to maturity and (2) its yield to call.

4–16

BUILD A MODEL:

BOND VALUATION

4–15

BOND VALUATION; FINANCIAL

CALCULATOR NEEDED

Spreadsheet Problem 185

Robert Balik and Carol Kiefer are vice-presidents of Mutual of Chicago Insurance Company

and codirectors of the company’s pension fund management division. A major new client, the

California League of Cities, has requested that Mutual of Chicago present an investment semi-

nar to the mayors of the represented cities, and Balik and Kiefer, who will make the actual pre-

sentation, have asked you to help them by answering the following questions. Because the Walt

Disney Company operates in one of the league’s cities, you are to work Disney into the presen-

tation.

a. What are the key features of a bond?

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

more or less risky?

c. How is the value of any asset whose value is based on expected future cash flows determined?

d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par value

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

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? (If you do not have

a financial calculator, PVIF13%,10
0.2946; PVIFA13%,10
5.4262.)

(2) What would happen to the bond’s value if inflation fell, and rddeclined to 7 percent?

Would we now have a premium or a discount bond?

(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.)

See Ch 04 Show.pptand
Ch 04 Mini Case.xls.

Bonds and Their Valuation 181