Chapter 06

Part3
ValuationofSecurities
ChaptersinthisPart
Chapter6
InterestRatesandBondValuation
Chapter7
StockValuation
Integrative Case 3: Encore International
Chapter6
InterestRatesandBondValuation
Instructors Resources
Overview
Thischapterbeginswithathoroughdiscussionofinterestrates,yieldcurves,andtheirrelationshipto
requiredreturns.Featuresofthemajortypesofbondissuesarepresentedalongwiththeirlegalissues,risk
characteristics,andindentureconvents.Thechapterthenintroducesstudentstotheimportantconceptof
valuationanddemonstratestheimpactofcashflows,timing,andriskonvalue.Itexplainsmodelsfor
valuingbondsandthecalculationofyieldtomaturityusingeitheranapproximateyieldformulaor
calculator.Studentslearnhowinterestratesmayaffecttheirabilitytoborrowandexpandbusiness
operationsorassetsunderpersonalcontrol.
Chapter6InterestRatesandBondValuation104
Suggested Answers to Opener in Review Questions

a. Withshortterminterestratesnear0percentin2010,supposetheTreasurydecidedtoreplace
maturingnotesandbondsbyissuingnewTreasurybills,thusshorteningtheaveragematurityof
U.S.debtoutstanding.Discusstheprosandconsofthisstrategy.
TheU.S.Treasurywouldfacemanyofthesameconsiderationsasthosefacedbyacompanythatis
consideringrevisionofitsaveragedebtmaturity.Shorttermratesarenormallylower,reducingtotal
financingcosts.However,iftheU.S.Treasuryreliesonshorttermratesandshorttermratesrise,the
costoffinancingthefederaldebtcouldendupbeinghigher.EvenmoreseriousistheriskthattheU.S.
TreasurymaynotbeabletofindbuyersofnewTreasurybillswhenoldTreasurybillsmature.
Accordingtomarketsegmentationtheory,thereisalimitedamountofdemandforshortterm
securities.Excessiveshorttermdemandmightpushupthecostofseasonalbusinessloanshigher,
hinderingbusinessandtaxrevenues.
AnotherconcernthattheU.S.Treasurywouldhavetofaceiswhetherthefinancingadjustmentwould
diminishthehighregardwithwhichTreasurybillsareheld.Currently,Treasurybillsareascloseaswe
cangettoariskfreerateintherealworld.Iftheamountofshorttermfinancingbecomesexcessive,
theabilityofthefederalgovernmenttomakegoodonitsshorttermrepaymentpromisesmaycome
intoquestion,nolongermakeitariskfreesurrogate,andincreaseTreasurybillrates.
b. TheaveragematurityofoutstandingU.S.Treasurydebtisabout5years.Supposeanewlyissued
5yearTreasurynotehasacouponrateof2percentandsellsforpar.Whathappenstothevalue
ofthisdebtiftheinflationraterises1percentagepoint,causingtheyieldtomaturityonthe5
yearnotetojumpto3percentshortlyafteritisissued?
2012PearsonEducation,Inc.PublishingasPrenticeHall
Debtpricedatparprovidesacouponpaymentsufficienttopaytherequiredrateofreturn.Hence,ifthe
requiredrateofreturnis2%,itmustbepaying$20annually.Ifthediscountrateincreases,thecoupon
paymentisnolongersufficient.Hence,thepricewoulddroptocreateaonepercentcapitalgainper
year,leadingupto$1,000atmaturity.Thepricewouldbe
N5, I3%,PMT$20,FV1,000
SolveforPV954.20
ThepriceoftheTreasurywoulddrop$45.80,or4.58percent,to$954.20.
c. AssumethattheaverageTreasurysecurityoutstandinghasthefeaturesdescribedinpartb.If
totalU.S.debtis$13trillionandanincreaseininflationcausesyieldsonTreasurysecuritiesto
increaseby1percentagepoint,byhowmuchwouldthemarketvalueofoutstandingdebtfall?
Whatdoesthissuggestabouttheincentivesofgovernmentpolicymakerstopursuepoliciesthat
couldleadtohigherinflation?
BasedontheinformationprovidedintheOpener,afewcalculationscanleadustoanapproximation
forthiscomplexandcomplicatedquestion.Weareinformedthat$383billionisthe2009interest
expenseandthatthenationaldebtwasabout$12trillionin2009(i.e.,$13trillionlessmorethan$1
trillionaccruedin2009).Divisionoftheinterestpaymentbythetotaldebtresultsinaninterestrateof
3.19percent(i.e.,$383billion$12trillion).AssumingtheTreasuriesarepricedatpar,oneendsup
with$31.90perthousandbeingtheannualpaymentneededtoresultinTreasuriesbeingpricedatpar.
Ifinterestratesriseby1%to4.19percent,thepriceofthefederaldebtwouldfallto$955.71,
ascomputedbelow.
N5,I4.19,PMT31.9,andFV$1,000
SolveforPV$955.71
ThedropinTreasuryvalueswouldbeabout4.4percent.Thiswoulddecreasethesizeofthefederal
debtby$572billion(0.044$13trillion).Hence,ifoneconsidersthesizeofthecurrentfederal
budgetdeficitinisolation,thereisanincentiveforthegovernmenttopursuepolicieswhichwilllead
tohigherinflation.However,higherpriceswillleadtohigherfuturecostsforgoodsandservices
purchasedbythegovernmentandanincreaseinthecostofentitlements,makingproperuseofinterest
ratestoproperlymanagethefederalbudgetdifficult,complicated,and,alas,political.
Answers to Review Questions

1. Therealrateofinterestistheratethatcreatesanequilibriumbetweenthesupplyofsavingsanddemand
forinvestmentfunds.Thenominalrateofinterestistheactualrateofinterestchargedbythesupplier
andpaidbythedemander.Thenominalrateofinterestdiffersfromtherealrateofinterestduetotwo
factors:(1)apremiumduetoinflationaryexpectations(IP)and(2)apremiumduetoissuerandissue
characteristicrisks(RP).Thenominalrateofinterestforasecuritycanbedefinedasr1r*IPRP.
Fora3monthU.S.Treasurybill,thenominalrateofinterestcanbestatedasr1r*IP.Thedefault
riskpremium,RP,isassumedtobezerosincethesecurityisbackedbytheU.S.government;thissecurity
iscommonlyconsideredtheriskfreeasset.
2. Thetermstructureofinterestratesistherelationshipoftherateofreturntothetimetomaturityfor
anyclassofsimilarrisksecurities.Thegraphicpresentationofthisrelationshipistheyieldcurve.
3. Foragivenclassofsecurities,theslopeofthecurvereflectsanexpectationaboutthemovementof
interestratesovertime.ThemostcommonlyusedclassofsecuritiesisU.S.Treasurysecurities.
a.
Downwardsloping:Longtermborrowingcostsarelowerthanshorttermborrowingcosts.
b. Upwardsloping:Shorttermborrowingcostsarelowerthanlongtermborrowingcosts.
c.
Flat:Borrowingcostsarerelativelysimilarforshortandlongtermloans.
Theupwardslopingyieldcurvehasbeenthemostprevalenthistorically.
4. a.
Accordingtotheexpectationstheory,theyieldcurvereflectsinvestorexpectationsaboutfuture
interestrates,withthedifferencesbasedoninflationexpectations.Thecurvecantakeanyofthe
threeforms.Anupwardslopingcurveistheresultofincreasinginflationaryexpectations,and
viceversa.
b. Theliquiditypreferencetheoryisanexplanationfortheupwardslopingyieldcurve.Thistheory
statesthatlongtermratesaregenerallyhigherthanshorttermratesduetothedesireofinvestors
forgreaterliquidity,andthusapremiummustbeofferedtoattractadequatelongterm
investment.
c.
Themarketsegmentationtheoryisanothertheorythatcanexplainanyofthethreecurveshapes.
Sincethemarketforloanscanbesegmentedbasedonmaturity,sourcesofsupplyanddemandfor
loanswithineachsegmentdeterminetheprevailinginterestrate.Ifsupplyisgreaterthandemand
forshorttermfundsatatimewhendemandforlongtermloansishigherthanthesupplyof
funding,theyieldcurvewouldbeupwardsloping.Obviously,thereversealsoholdstrue.
5. IntheFisherequation,rr*IPRP,theriskpremium,RP,consistsofthefollowingissuerand
issuerelatedcomponents:
Defaultrisk:Thepossibilitythattheissuerwillnotpaythecontractualinterestorprincipalas
scheduled.
Maturity(interestrate)risk:Thepossibilitythatchangesintheinterestratesonsimilarsecuritieswill
causethevalueofthesecuritytochangebyagreateramountthelongeritsmaturity,andviceversa.
Liquidityrisk:Theeasewithwhichsecuritiescanbeconvertedtocashwithoutalossinvalue.
Contractualprovisions:Covenantsincludedinadebtagreementorstockissuedefiningtherights
andrestrictionsoftheissuerandthepurchaser.Thesecanincreaseorreducetheriskofasecurity.
Taxrisk:Certainsecuritiesissuedbyagenciesofstateandlocalgovernmentsareexemptfrom
federal,andinsomecasesstateandlocaltaxes,therebyreducingthenominalrateofinterestbyan
amountthatbringsthereturnintolinewiththeaftertaxreturnonataxableissueofsimilarrisk.
Therisksthataredebtspecificaredefault,maturity,andcontractualprovisions.
6. Mostcorporatebondsareissuedindenominationsof$1,000withmaturitiesof10to30years.The
statedinterestrateonabondrepresentsthepercentageofthebondsparvaluethatwillbepaidout
annually,althoughtheactualpaymentsmaybedividedupandmadequarterlyorsemiannually.
Bothbondindenturesandtrusteesaremeansofprotectingthebondholders.Thebondindentureisa
complexandlengthylegaldocumentstatingtheconditionsunderwhichabondisissued.Thetrustee
maybeapaidindividual,corporation,orcommercialbanktrustdepartmentthatactsasathirdparty
watchdogonbehalfofthebondholderstoensurethattheissuerdoesnotdefaultonitscontractual
commitmenttothebondholders.
7. Longtermlendersincluderestrictivecovenantsinloanagreementsinordertoplacecertainoperating
and/orfinancialconstraintsontheborrower.Theseconstraintsareintendedtoassurethelenderthat
theborrowingfirmwillmaintainaspecifiedfinancialconditionandmanagerialstructureduringthe
termoftheloan.Sincethelenderiscommittingfundsforalongperiodoftime,heseekstoprotect
himselfagainstadversefinancialdevelopmentsthatmayaffecttheborrower.Therestrictive
provisions(alsocallednegativecovenants)differfromthesocalledstandarddebtprovisionsinthat
theyplacecertainconstraintsonthefirmsoperations,whereasthestandardprovisions(alsocalled
affirmativecovenants)requirethefirmtooperateinarespectableandbusinesslikemanner.Standard
provisionsincludesuchrequirementsasprovidingauditedfinancialstatementsonaregularschedule,
payingtaxesandliabilitieswhendue,maintainingallfacilitiesingoodworkingorder,andkeeping
accountingrecordsinaccordancewithgenerallyacceptedaccountingprocedures(GAAP).
Violationofanyofthestandardorrestrictiveloanprovisionsgivesthelendertherighttodemand
immediaterepaymentofbothaccruedinterestandprincipaloftheloan.However,thelenderdoesnot
normallydemandimmediaterepaymentbutinsteadevaluatesthesituationinordertodetermineifthe
violationisseriousenoughtojeopardizetheloan.Thelendersoptionsare:Waivetheviolation,waive
theviolationandrenegotiatetermsoftheoriginalagreement,ordemandrepayment.
8. Shorttermborrowingisnormallylessexpensivethanlongtermborrowingduetothegreateruncertainty
associatedwithlongermaturityloans.Themajorfactorsaffectingthecostoflongtermdebt(orthe
interestrate),inadditiontoloanmaturity,areloansize,borrowerrisk,andthebasiccostofmoney.
9. Ifabondhasaconversionfeature,thebondholdershavetheoptionofconvertingthebondintoa
certainnumberofsharesofstockwithinacertainperiodoftime.Acallfeaturegivestheissuerthe
opportunitytorepurchase,orcall,bondsatastatedpricepriortomaturity.Itprovidesextra
compensationtobondholdersforthepotentialopportunitylossesthatwouldresultifthebondwere
calledduetodeclininginterestrates.Thisfeatureallowstheissuertoretireoutstandingdebtpriorto
maturityand,inthecaseofconvertibles,toforceconversion.Stockpurchasewarrants,whichare
sometimesincludedaspartofabondissue,givetheholdertherighttopurchaseacertainnumberof
sharesofcommonstockataspecifiedprice.
10. Currentyieldsarecalculatedbydividingtheannualinterestpaymentbythecurrentprice.Bonds
arequotedinpercentageofparterms,tothethousandthsplace.Hence,corporatebondpricesare
effectivelyquotedindollarsandcents.Aquoteof98.621meansthebondispricedat98.621%of
par,or$986.21.
BondsareratedbyindependentratingagenciessuchasMoodysandStandard&Poorswithrespect
totheiroverallquality,asmeasuredbythesafetyofrepaymentofprincipalandinterest.Ratingsare
theresultofdetailedfinancialratioandcashflowanalysesoftheissuingfirm.Thebondrating
affectstherateofreturnonthebond.Thehighertherating,thelessriskandthelowertheyield.
11. Eurobondsarebondsissuedbyaninternationalborrowerandsoldtoinvestorsincountrieswith
currenciesotherthanthatinwhichthebondisdenominated.Forexample,adollardenominated
EurobondissuedbyanAmericancorporationcanbesoldtoFrench,German,Swiss,orJapanese
investors.Aforeignbond,ontheotherhand,isissuedbyaforeignborrowerinahostcountrys
capitalmarketanddenominatedinthehostcurrency.AnexampleisaFrenchfrancdenominated
bondissuedinFrancebyanEnglishcompany.
12. Afinancialmanagermustunderstandthevaluationprocessinordertojudgethevalueofbenefits
receivedfromstocks,bonds,andotherassetsinviewoftheirrisk,return,andcombinedimpacton
sharevalue.
13. Threekeyinputstothevaluationprocessare:
a.
Cashflowsthecashgeneratedfromownershipoftheasset;
b. Timingthetimeperiod(s)inwhichcashflowsarereceived;and
c.
RequiredreturntheinterestrateusedtodiscountthefuturecashflowstoaPV.Theselectionof
therequiredreturnallowsthelevelofrisktobeadjusted;thehighertherisk,thehigherthe
requiredreturn(discountrate).
14. Thevaluationprocessappliestoassetsthatprovideanintermittentcashfloworevenasinglecash
flowoveranytimeperiod.
15. ThevalueofanyassetisthePVoffuturecashflowsexpectedfromtheassetovertherelevanttime
period.Thethreekeyinputsinthevaluationprocessarecashflows,therequiredrateofreturn,and
thetimingofcashflows.Theequationforvalueis:
V0
CFn
CF1
CF2
L
(1 r )1 (1 r )2
(1 r )n
where:
V0
valueoftheassetattimezero
CF1 cashflowexpectedattheendofyeart
r
appropriaterequiredreturn(discountrate)
relevanttimeperiod
16. Thebasicbondvaluationequationforabondthatpaysannualinterestis:
V0 I
(1 r )
t 1
1
n
(1 rd )
where:
V0 valueofabondthatpaysannualinterest
I
interest
n yearstomaturity
M dollarparvalue
rd requiredreturnonthebond
Tofindthevalueofbondspayinginterestsemiannually,thebasicbondvaluationequationisadjusted
asfollowstoaccountforthemorefrequentpaymentofinterest:
a.
Theannualinterestmustbeconvertedtosemiannualinterestbydividingbytwo.
b. Thenumberofyearstomaturitymustbemultipliedbytwo.
c.
Therequiredreturnmustbeconvertedtoasemiannualratebydividingitbytwo.
17. Abondsellsatadiscountwhentherequiredreturnexceedsthecouponrate.Abondsellsata
premiumwhentherequiredreturnislessthanthecouponrate.Abondsellsatparvaluewhenthe
requiredreturnequalsthecouponrate.Thecouponrateisgenerallyafixedrateofinterest,whereas
therequiredreturnfluctuateswithshiftsinthecostoflongtermfundsduetoeconomicconditions
and/orriskoftheissuingfirm.Thedisparitybetweentherequiredrateandthecouponratewillcause
thebondtobesoldatadiscountorpremium.
18. Iftherequiredreturnonabondisconstantuntilmaturityanddifferentfromthecouponinterestrate,
thebondsvalueapproachesits$1,000parvalueasthetimetomaturitydeclines.
19. Toprotectagainsttheimpactofrisinginterestrates,ariskaverseinvestorwouldpreferbondswith
shortperiodsuntilmaturity.Theresponsivenessofthebondsmarketvaluetointerestrate
fluctuationsisanincreasingfunctionofthetimetomaturity.
20. Theyieldtomaturity(YTM)onabondistherateinvestorsearniftheybuythebondataspecific
priceandholdituntilmaturity.TheYTMcanbefoundpreciselybyusingahandheldfinancial
calculatorandusingthetimevaluefunctions.EntertheB0asthePV,andtheIastheannualpayment,
andthenasthenumberofperiodsuntilmaturity.Havethecalculatorsolvefortheinterestrate.This
interestvalueistheYTM.Manycalculatorsarealreadyprogrammedtosolvefortheinternalrateof
return(IRR).UsingthisfeaturewillalsoobtaintheYTMsincetheYTMandIRRaredeterminedthe
sameway.Spreadsheetsincludeaformulaforcomputingtheyieldtomaturity.
Suggested Answer to Focus on Practice Box:

I-Bonds Adjust for Inflation
WhateffectdoyouthinktheinflationadjustedinterestratehasonthecostofanIbondin
comparisonwithsimilarbondswithnoallowanceforinflation?
ThecostoftheIbondwhenissuedisthefacevalue($50,$75,$100,$200,$500,$1,000,$5,000,and
$10,000).Becausethebondhasaninflationprotectionfeature,theTreasuryDepartmentcanissuethe
Ibondatslightlylowerinterestratesthancomparablebonds.
Suggested Answer to Focus on Ethics Box:

Can We Trust the Bond Raters?
Whatethicalissuesmayarisebecausethecompaniesthatissuebondspaytheratingagencies
toratetheirbonds?
Theratingagencieshaveanincentivetokeeptheircustomers(i.e.,theissuers)happyinordertosecure
futurebusiness.Somesuggestthattherelationshipbetweentheagenciesandtheissuersisoneofthe
factorsthatcontributedtothesubprimecrisis.Theconcernisthatratingagenciesmighthesitatetogive
lowratings,fearingthatbondissueswouldnolongerpaytohavetheirbondsrated.
Answers to Warm-Up Exercises
E61.
Findingtherealrateofinterest
Answer:
r*RFIP
0.8%1.23%IP
IP1.230.080.43%
E62.
Yieldcurve
b. {(4.51%10)(3.7%5)}5
{45.1%18.5%}5
26.6%55.32%
c. (3.01%3)(2.68%2)9.03%5.36%3.67%
d. Yieldcurvesmayslopeupformanyreasonsbeyondexpectationsofrisinginterestrates.According
toliquiditypreferencetheory,longterminterestratestendtobehigherthanshorttermrates
becauselongertermdebthaslowerliquidity,higherresponsivenesstogeneralinterestrate
movements,andborrowerwillingnesstopayahigherinterestratetolockinmoneyfora
longerperiodoftime.Inadditiontoexpectationstheoryandliquiditypreferencetheory,
marketsegmentationtheoryallowsforadditionalinterestrateincreasesarisingfromeither
limitedavailabilityoffundsorgreaterdemandforfundsatlongermaturities.
E63.
Calculatinginflationexpectation
Answer: Theinflationexpectationforaspecificmaturityisthedifferencebetweentheyieldandthereal
interestrateatthatmaturity.
E64.
Maturity
Yield
RealRateofInterest
InflationExpectation
3months
1.41%
0.80%
0.61%
6months
1.71
0.80
0.91
2years
2.68
0.80
1.88
3years
3.01
0.80
2.21
5years
3.70
0.80
2.90
10years
4.51
0.80
3.71
30years
5.25
0.80
4.45
Realreturns
Answer: ATbillcanexperienceanegativerealreturnifitsinterestrateislessthantheinflationrateas
measuredbytheCPI.TherealreturnwouldbezeroiftheTbillratewas3.3%exactlymatching
theCPIrate.Toobtainaminimum2%realreturn,theTbillratewouldhavetobeatleast5.3%.
E65.
Calculatingriskpremium
Answer: Wecalculatetheriskpremiumofothersecuritiesbysubtractingtheriskfreerate,4.51%,from
eachnominalinterestrate.
Security
AAA
NominalInterestRate
RiskPremium
5.12%
5.12%4.51%0.61%
E66.
BBB
5.78
5.78%4.51%1.27%
7.82
7.82%4.51%3.31%
Thebasicvaluationmodel
Answer: FindthePVofthecashflowstreamforeachassetbydiscountingtheexpectedcashflows
usingtherespectiverequiredreturn.
Asset1:
PV$5000.15$3,333.33
PV
$1,200 $1,500 $850
$2,969.20
1.10
(1.10)2 (1.10)3
Asset2:
E67.
CalculatingthePVofabondwhentherequiredreturnexceedsthecouponrate
Answer: ThePVofabondisthePVofitsfuturecashflows.Inthecaseofthe5yearbond,theexpected
cashflowsare$1,200attheendofeachyearfor5years,plusthefacevalueofthebondthat
willbereceivedatthematurityofthebond(endofyear5).Youmayusethebondvaluation
formulafoundinyourtextoryoumayuseafinancialcalculator.Thesolutionpresentedbelow
isderivedusingafinancialcalculator.Setthecalculatoron1period/year.
PVofinterest:
PMT1,200
I8%/year
N5periods
SolveforPV$4,791.25
PVofthebondsfacevalue:
FV$20,000
N5periods
I8%/year
SolveforPV$13,611.66
ThePVofthisbondis$4,791.25$13,611.66$18,402.91.
Thisanswerisconsistentwiththeknowledgethatwheninterestratesrise,thevaluesof
previouslyissuedbondsfall.Thepresentvalueisacashoutflow,orcosttoinvestor.
E68.
Bondvaluationsusingrequiredratesofreturn
Answer: a.
b.
Studentanswerswillvarybutanyrequiredrateofreturnabovethecouponratewillcause
thebondtosellatadiscount,whileatarequiredreturnof4.5%thebondwillsellatpar.
Anyrequiredrateofreturnbelowthecouponratewillcausethebondtosellatapremium.
Studentanswerswillvarybutshouldbeconsistentwiththeiranswerstoparta.
Solutions to Problems
P61.
Interestratefundamentals:Therealrateofreturn
LG1;Basic
Realrateofreturn5.5%3.0%2.5%
P62.
Realrateofinterest
LG1;Intermediate
a.
b. Therealrateofinterestcreatesanequilibriumbetweenthesupplyofsavingsandthedemand
forfunds,whichisshownonthegraphastheintersectionoflinesforcurrentsuppliersand
currentdemanders;r4%.
c.
Seegraph.
d. Achangeinthetaxlawcausesanupwardshiftinthedemandcurve,causingtheequilibrium
pointbetweenthesupplycurveandthedemandcurve(therealrateofinterest)torisefrom
r04%tor06%(intersectionoflinesforcurrentsuppliersanddemandersafternewlaw).
P63.
Personalfinance:Realandnominalratesofinterest
LG1;Intermediate
a.
4shirts
b. $100($1000.09)$109
c.
$25($25.05)$26.25
d. Thenumberofpoloshirtsinoneyear$109$26.254.1524.Hecanbuy3.8%more
shirts(4.152440.0381).
e.
Therealrateofreturnis9%5%4%.Thechangeinthenumberofshirtsthatcanbe
purchasedisdeterminedbytherealrateofreturnsincetheportionofthenominalreturnfor
expectedinflation(5%)isavailablejusttomaintaintheabilitytopurchasethesamenumber
ofshirts.
P64.
Yieldcurve
LG1;Intermediate
a.
b. Theyieldcurveisslightlydownwardsloping,reflectinglowerexpectedfutureratesof
interest.Thecurvemayreflectageneralexpectationforaneconomicrecoverydueto
inflationcomingundercontrolandastimulatingimpactontheeconomyfromthelowerrates.
However,aslowingeconomymaydiminishtheperceivedneedforfundsandtheresulting
interestratebeingpaidforcash.Obviously,thesecondscenarioisnotgoodforbusinessand
highlightsthechallengeofforecastingthefuturebasedonthetermstructureofinterestrates.
P65.
Nominalinterestratesandyieldcurves
LG1;Challenge
a.
rlr*IPRP1
ForU.S.Treasuryissues,RP0
rFr*IP
20yearbond:
RF2.5%9%11.5%
3monthbill:
RF2.5%5%7.5%
2yearnote:
RF2.5%6%8.5%
5yearbond:
RF2.5%8%10.5%
b. Iftherealrateofinterest(r* )dropsto2.0%,thenominalinterestrateineachcasewould
decreaseby0.5%point.
c.
TheyieldcurveforU.S.Treasuryissuesisupwardsloping,reflectingtheprevailing
expectationofhigherfutureinflationrates.
d. Followersoftheliquiditypreferencetheorywouldstatethattheupwardslopingshapeofthe
curveisduetothedesirebylenderstolendshorttermandthedesirebybusinesstoborrow
longterm.Thedashedlineinthepartcgraphshowswhatthecurvewouldlooklikewithout
theexistenceofliquiditypreference,ignoringtheotheryieldcurvetheories.
e.
P66.
Marketsegmentationtheoristswouldarguethattheupwardslopeisduetothefactthatunder
currenteconomicconditionsthereisgreaterdemandforlongtermloansforitemssuchasreal
estatethanforshorttermloanssuchasseasonalneeds.
Nominalandrealratesandyieldcurves
LG1;Challenge
Realrateofinterest(r* ):
ri r*IPRP
RP0forTreasuryissues
r* riIP
a.
Nominal
Rate(rj)
IP
RealRateof
Interest(r* )
12.6%
9.5%
3.1%
11.2%
8.2%
3.0%
13.0%
10.0%
3.0%
11.0%
8.1%
2.9%
11.4%
8.3%
3.1%
Security
b. TherealrateofinterestdecreasedfromJanuarytoMarch,remainedstablefromMarch
throughAugust,andfinallyincreasedinDecember.Forcesthatmayberesponsible
forachangeintherealrateofinterestincludechangingeconomicconditionssuchasthe
internationaltradebalance,afederalgovernmentbudgetdeficit,orchangesintaxlegislation.
c.
d. Theyieldcurveisslightlydownwardsloping,reflectinglowerexpectedfutureratesof
interest.Thecurvemayreflectacurrent,generalexpectationforaneconomicrecoverydueto
inflationcomingundercontrolandastimulatingimpactontheeconomyfromthelowerrates.
P67.
Termstructureofinterestrates
LG1;Intermediate
a.
b.andc.
Fiveyearsago,theyieldcurvewasrelativelyflat,reflectingexpectationsofstableinterest
rates.Twoyearsago,theyieldcurvewasdownwardsloping,reflectinglowerexpected
interestrates,whichcouldbeduetoadeclineintheexpectedlevelofinflation.Today,the
yieldcurveisupwardsloping,reflectinghigherexpectedfutureratesofinterest.
d. Fiveyearsago,the10yearbondwaspaying9.5%,whichwouldresultinapproximately95%
ininterestoverthecomingdecade.Atthesametime,the5yearbondwaspayingjust9.3%,
oratotalof46.5%overthefiveyears.Accordingtotheexpectationstheory,investorsmust
haveexpectedthecurrent5yearratetobe9.7%becauseatthatrate,thetotalreturnoverten
yearswouldhavebeenthesameona10yearbondandontwoconsecutive5yearbonds.The
numbersaregivenbelow.
{(9.5%10)(9.3%5)}5
{95%46.5%}5
48.6%59.7%
P68.
Riskfreerateandriskpremiums
LG1;Basic
a.
Riskfreerate:RFr*IP
Security
r*
IP
RF
3%
6%
9%
3%
9%
12%
3%
8%
11%
3%
5%
8%
3%
11%
14%
b. Sincetheexpectedinflationratesdiffer,itisprobablethatthematurityofeachsecuritydiffers.
c.
Nominalrate:rr*IPRP
Security
r*
IP
RP
3%
6%
3%
12%
3%
9%
2%
14%
3%
8%
2%
13%
3%
5%
4%
12%
3%
11%
1%
15%
P69.
Riskpremiums
LG1;Intermediate
a.
RFtr*IPt
SecurityA:RF32%9%11%
SecurityB:RF152%7%9%
b. Riskpremium:
RPdefaultriskmaturityriskliquidityriskotherrisk
SecurityA:RP1%0.5%1%0.5%3%
SecurityB:RP2%1.5%1%1.5%6%
c.
rir*IPRPorr1rFriskpremium
SecurityA:r111%3%14%
SecurityB:r19%6%15%
SecurityAhasahigherriskfreerateofreturnthanSecurityBduetoexpectationsofhighernear
terminflationrates.TheissuecharacteristicsofSecurityAincomparisontoSecurityBindicate
thatSecurityAislessrisky.
P610. Bondinterestpaymentsbeforeandaftertaxes
LG2;Intermediate
a.
Yearlyinterest[($2,500,000/2500)0.07]($1,0000.07)$70.00
b. Totalinterestexpense$70.00perbond2,500bonds$175,000
c.
Totalbeforetaxinterest
$175,000
Interestexpensetaxsavings(0.35$175,000)
Netaftertaxinterestexpense
61,250
$113,750
P611. Bondpricesandyields
LG4;Basic
a.
0.97708$1,000$977.08
b. (0.05700$1,000) $977.08$57.000 $977.080.05835.83%

c.
Thebondissellingatadiscounttoits$1,000parvalue.
d. Theyieldtomaturityishigherthanthecurrentyield,becausetheformerincludes$22.92in
priceappreciationbetweentodayandtheMay15,2017bondmaturity.
P612. Personalfinance:Valuationfundamentals
LG4;Basic
a.
Cashflows:
CF1 5
$1,200
CF5
$5,000
Requiredreturn:6%
V0
CF3
CF5
CF1
CF2
CF4
1
2
3
4
(1 r ) (1 r ) (1 r ) (1 r ) (1 r )5
V0
$1,200
$1,200
$1,200
$1,200
$6,200
1
2
3
4
(1 0.06) (1 0.06) (1 0.06) (1 0.06) (1 0.06)5
b.
V0 $8,791
UsingCalculator:
N5,I6,PMT$1,200,FV$5,000
SolveforPV:$8791
Themaximumpriceyoushouldbewillingtopayforthecaris$8,791,sinceifyoupaidmore
thanthatamount,youwouldbereceivinglessthanyourrequired6%return.
P613. Valuationofassets
LG4;Basic
PresentValueof
Asset
A
EndofYear
1
2
Amount
$5,000
$5,000
$5,000
$300
N5,I16
FV$35,000
$35,000
15
$1,500
N3,I18
PMT$5,000
10.15
N6,I12,
CashFlows
$10,871.36
$2,000
$16,663.96
$9,713.53
8,500
PMT$1,500
FV$7,000
$2,000
3,000
5,000
7,000
4,000
1,000
UseCashFlow
Worksheet
$14,115.27
P614. Personalfinance:Assetvaluationandrisk
LG4;Intermediate
a.
@10%
LowRisk
@15%
AverageRisk
@22%
HighRisk
PMT
CF14
$3,000
$9,510
$8,565
$7,481
CF5
15,000
9,314
7,455
5,550
$16,022.59
$13,030.91
Calculatorsolutions: $18,823.42
b. ThemaximumpriceLaurashouldpayis$13,030.92.Unabletoassesstherisk,Laurawould
usethemostconservativeprice,thereforeassumingthehighestrisk.
c.
Byincreasingtheriskofreceivingcashflowfromanasset,therequiredrateofreturn
increases,whichreducesthevalueoftheasset.
P615. Basicbondvaluation
LG5;Intermediate
a.
I10%,N16,PMT$120,FV$1,000
SolveforPV$1,156.47
b. SinceComplexSystemsbondswereissued,theremayhavebeenashiftinthesupply
demandrelationshipformoneyorachangeintheriskofthefirm.
c.
I12%,N16,PMT$120,FV$1,000
SolveforPV:$1,000
Whentherequiredreturnisequaltothecouponrate,thebondvalueisequaltotheparvalue.
Incontrasttopartaabove,iftherequiredreturnislessthanthecouponrate,thebondwillsell
atapremium(itsvaluewillbegreaterthanpar).
P616. Bondvaluationannualinterest
LG5;Basic
Bond
CalculatorInputs
CalculatorSolution
N20,I12,PMT0.14$1,000$140,FV1,000
$1,149.39
N16,I8,PMT0.08$1,000$80,FV$1,000
$1,000.00
N8,I13,PMT0.10$100$10,FV$100
$85.60
N13,I18,PMT0.16$500$80,FV$500
$450.90
N10,I10,PMT0.12$1,000$120,FV$1,000
$1,122.89
P617. Bondvalueandchangingrequiredreturns
LG5;Intermediate
a.
Bond
CalculatorInputs
CalculatorSolution
(1)
N12,I11%,PMT$110,FV$1,000
$1,000.00
(2)
N12,I15%,PMT$110,FV$1,000
$783.18
(3)
N12,I8%,PMT$110,FV$1,000
$1,226.08
b.
c.
Whentherequiredreturnislessthanthecouponrate,themarketvalueisgreaterthanthepar
valueandthebondsellsatapremium.Whentherequiredreturnisgreaterthanthecoupon
rate,themarketvalueislessthantheparvalue;thebondthereforesellsatadiscount.
d. Therequiredreturnonthebondislikelytodifferfromthecouponinterestratebecauseeither
(1) economicconditionshavechanged,causingashiftinthebasiccostoflongtermfunds,or
(2) thefirmsriskhaschanged.
P618. Bondvalueandtimeconstantrequiredreturns
LG5;Intermediate
a.
Bond
CalculatorInputs
CalculatorSolution
(1)
N15,I14%,PMT$120,FV$1,000
$877.16
(2)
N12,I14%,PMT$120,FV$1,000
$886.79
(3)
(4)
(5)
N9,I14%,PMT$120,FV$1,000
N6,I14%,PMT$120,FV$1,000
N3,I14%,PMT$120,FV$1,000
$901.07
$922.23
$953.57
(6)
N1,I14%,PMT$120,FV$1,000
$982.46
b.
c.
Thebondvalueapproachestheparvalue.
P619. Personalfinance:Bondvalueandtimechangingrequiredreturns
LG5;Challenge
a.
Bond
CalculatorInputs
CalculatorSolution
(1)
N5,I8%,PMT$110,FV$1,000
$1,119.78
(2)
N5,I11%,PMT$110,FV$1,000
$1,000.00
(3)
N5,I14%,PMT$110,FV$1,000
$897.01
b.
Bond
TableValues
CalculatorSolution
(1)
N15,I8%,PMT$110,FV$1,000
$1,256.78
(2)
N15,I11%,PMT$110,FV$1,000
$1,000.00
(3)
N15,I14%,PMT$110,FV$1,000
$815.73
c.
Value
RequiredReturn
BondA
BondB
8%
$1,119.78
$1,256.75
11%
1,000.00
1,000.00
14%
897.01
815.73
Thegreaterthelengthoftimetomaturity,themoreresponsivethemarketvalueofthebond
tochangingrequiredreturns,andviceversa.
d. IfLynnwantstominimizeinterestrateriskinthefuture,shewouldchooseBondAwiththe
shortermaturity.AnychangeininterestrateswillimpactthemarketvalueofBondAless
thanifsheheldBondB.
P620. Yieldtomaturity
LG6;Basic
BondAissellingatadiscounttopar.
BondBissellingatparvalue.
BondCissellingatapremiumtopar.
BondDissellingatadiscounttopar.
BondEissellingatapremiumtopar.
P621. Yieldtomaturity
LG6;Intermediate
a.
Usingafinancialcalculator,theYTMis12.685%.Thecorrectnessofthisnumberisproven
byputtingtheYTMinthebondvaluationmodel.Thisproofisasfollows:
N15,I12.685%,PMT$120,FV$1,000
SolveforPV$955.00
SincePVis$955.00andthemarketvalueofthebondis$955,theYTMisequaltotherate
derivedonthefinancialcalculator.
b. Themarketvalueofthebondapproachesitsparvalueasthetimetomaturitydeclines.The
yieldtomaturityapproachesthecouponinterestrateasthetimetomaturitydeclines.
P622. LG6:Yieldtomaturity
LG6;Intermediate
a.
Calculator
Bond
ApproximateYTM
$90 [($1,000 $820) 8]
[($1,000 $820) 2]
12.36%
12.00%
$10.38%
$150 [($1,000 $1,120) 10]
[($1,000 $1,120 2]
13.02%
$50 [($1,000 $900) 3]

[($1,000 $900) 2]
12.71%
12.00%
$60 [($500 $560) 12]

[($500 $560) 2]
Solution
8.77%
10.22%
12.81%
8.95%
b. Themarketvalueofthebondapproachesitsparvalueasthetimetomaturitydeclines.The
yieldtomaturityapproachesthecouponinterestrateasthetimetomaturitydeclines.CaseB
highlightsthefactthatifthecurrentpriceequalstheparvalue,thecouponinterestrateequals
theyieldtomaturity(regardlessofthenumberofyearstomaturity).
P623. Personalfinance:Bondvaluationandyieldtomaturity
LG2,5,6;Challenge
a.
N5,I12%,PMT0.06$1,000$60;FV$1,000
SolveforPV$783.71
N5,I12%,PMT0.14$1,000$140;FV$1,000
SolveforPV$1,072.10
b. NumberofBondAbonds$20,000$783.7125.520
NumberofBondBbonds$20,000$1072.1018.655
c.
InterestincomeofA25.520bonds$60$1,531.20
InterestincomeofB18.655bonds$140$2,611.70
d. Attheendofthe5yearsbothbondsmatureandwillsellforparof$1,000.
N5,I10%,PMT$60,SolveforFV$366.31
Totalfuturecashflows:$366.31$1,000$1,366.31
N5,I10%,PMT$140,SolveforFV$854.71
Totalfuturecashflows:$854.71$1,000$1,854.71
e.
Thedifferenceisduetothedifferencesininterestpaymentsreceivedeachyear.Theprincipal
paymentsatmaturitywillbethesameforbothbonds.Usingthecalculator,theyieldto
maturityofBondAis11.77%andtheyieldtomaturityofBondBis11.59%withthe10%
reinvestmentratefortheinterestpayments.MarkwouldbebetteroffinvestinginBondA.
Thereasoningbehindthisresultisthatforbothbondstheprincipalispricedtoyield12%.
However,BondBismoredependentuponthereinvestmentofthelargecouponpaymentat
theyieldtomaturitytoearnthe12%thanisthelowercouponpaymentofBondA.
P624. Bondvaluationsemiannualinterest
LG6;Intermediate
N6212,I1427%,PMT0.10$1,0002$50;FV$1,000
SolveforPV$$841.15
P625. Bondvaluationsemiannualinterest
LG6;Intermediate
Bond
ComputerInputs
CalculatorSolution
N24,I4%,PMT$50,FV$1,000
$1,152.47
N40,I6%,PMT$60,FV$1,000
$1,000.00
N10,I7%,PMT$30,FV$500
$464.88
N20,I5%,PMT$70,FV$1,000
$1,249.24
N8,I7%,PMT$3,FV$100
$76.11
P626. Bondvaluationquarterlyinterest
LG6;Challenge
N41040,I12%43.0%,PMT3,PMT0.10$5,0004$125,FV$5,000
SolveforPV$4,422.13
P627. Ethicsproblem
LG6;Intermediate
Studentanswerswillvary.Somestudentsmayarguethatsuchapolicydecreasesthereliability
oftheratingagencysbondratingssincetheratingisnotpurelybasedonthequantitativeand
nonquantitativefactorsthatshouldbeconsidered.Oneofthegoalsofthenewlawistodiscourage
suchapractice.Otherstudentsmayarguethat,likealossleader,ratingsareawaytogenerate
additionalbusinessfortheratingfirm.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Evaluating Annie Heggs Proposed Investment in Atilier Industries Bonds

Thiscasedemonstrateshowariskyinvestmentcanaffectafirmsvalue.First,studentsmustcalculate
thecurrentvalueofAtiliersbonds,reworkthecalculationsassumingthatthefirmmakestherisky
investment,andthendrawsomeconclusionsaboutthevalueofthefirminthissituation.Inadditionto
gainingexperienceinvaluationofbonds,studentswillseetherelationshipbetweenriskandvaluation.
a.
Annieshouldconvertthebonds.Thevalueofthestockifthebondisconvertedis:
50shares$30pershare$1,500
whileifthebondwasallowedtobecalledinthevaluewouldbeon$1,080
b.
Currentvalueofbondunderdifferentrequiredreturnsannualinterest
1. N25,I6%,PMT$80,FV$1,000
SolveforPV$1,255.67
Thebondwouldbeatapremium.
2. N25,I8%,PV$80,FV$1,000
SolveforPV$999.92
Thebondwouldsellingataboutitsparvalue.
3. N25,I10%,PMT$80,FV$1,000
SolveforPV$818.46
Thebondwouldbeatadiscount.
c.
Currentvalueofbondunderdifferentrequiredreturnssemiannualinterest
1. N50,I3%,PMT$40,FV$1,000
SolveforPV$1,257.30
Thebondwouldbeatapremium.
2. N50,I4%,PMT$40,FV$1,000
SolveforPV$1,000.00
Thebondwouldbeatparvalue.
3. N50,I5%,PMT$40,FV$1,000
SolveforPV$817.44
Thebondwouldbeatadiscount.
Underallthreerequiredreturnsforbothannualandsemiannualinterestpaymentsthebondsare
consistentintheirdirectionofpricing.Whentherequiredreturnisabove(below)thecouponthe
bondsellsatadiscount(premium).Whentherequiredreturnandcouponareequalthebondsells
atpar.Whenthechangeismadefromannualtosemiannualpaymentsthevalueofthepremiumand
parvaluebondsincreasewhilethevalueofthediscountbonddecreases.Thisdifferenceisduetothe
highereffectivereturnassociatedwithcompoundingfrequencymoreoftenthanannual.
d.
Ifexpectedinflationincreasesby1%therequiredreturnwillincreasefrom8%to9%,andthebond
pricewoulddropto$901.77.ThisamountisthemaximumAnnieshouldpayforthebond.
N25,I9%,PMT$80,FV$1,000
SolveforPV$901.77
e.
Thevalueofthebondwoulddeclineto$924.81duetothehigherrequiredreturnandtheinverse
relationshipbetweenbondyieldsandbondvalues.
N25,I8.75%,PMT$80,FV$1,000
SolveforPV$924.81
f.
Thebondwouldincreaseinvalueandagainof$110.61wouldbeearnedbyAnnie.
N22,I7%,PMT$80,PV$1,000
SolveforPV$1,110.61
g.
Thebondwouldincreaseinvalueandagainof$91.08wouldbeearnedbyAnnie.
Bondvalueat7%and15yearstomaturity.
N15,I7%,PMT$80,FV$1,000
SolveforPV$1,091.08
Thebondismoresensitivetointerestratechangeswhenthetimetomaturityislonger(22years)than
whenthetimetomaturityisshorter(15years).Maturityriskdecreasesasthebondgetsclosertomaturity.
h.
AntilierIndustriesprovidesayieldof8%($80),andispricedat$983.80(0.983801,000).Hence,
thecurrentyieldis80/983.800.0813,orabout8.13%.UsingthecalculatortheYTMonthisbond
assumingannualinterestpaymentsof$80,25yearstomaturity,andacurrentpriceof$983.80would
be8.15%.
i.
AnnieshouldprobablynotinvestintheAtilierbond.Thereareseveralreasonsforthisconclusion.
1. Thetermtomaturityislongandthusthematurityriskishigh.
2. Anincreaseininterestratesislikelyduetothepotentialdowngradingofthebond,thusdriving
thepricedown.
3. Anincreaseininterestratesislikelyduetothepossibilityofhigherinflation,thusdrivingthe
pricedown.
4. Thepriceof$983.75iswellaboveherminimumpriceof$901.77assuminganincreasein
interestratesof1%.
Spreadsheet Exercise
TheanswertoChapter6sCSMCorporationspreadsheetproblemislocatedontheInstructorsResource
Centeratwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Thischapterisconcernedwithcreditratings.Eachgroupisaskedtousecurrentinformationfromtheir
shadowfirmtofleshoutthedetailsfortheirfictitiousfirm.Thefirstlessonstudentswilllearnisthelack
oftransparencyinthebondmarket,particularlywhencomparedtothestockmarket.Updatedinformation
isnotaseasilycomparedacrossmultiplesitesanddetailsareoftensketchy.Sincearecentdebtissuance
isneededtheassignmentcanberedirectedfrompubliclyaccessedwebsitestothemostrecentfilingswith
theSEC.
Thestepsfortheassignmentareverystraightforward.Eachgroupisaskedtoretrievetheinterestrateof
arecentdebtissuance.Formanyfirmstherewillbemultipleofferings;anyrecentfilingwillsuffice.This
informationonratesisthencombinedwiththecreditratingoftheoffering.Studentsshouldrealizethe
samefirmcanbegivendifferentratingsondifferentofferingsaccordingtoeachofferingscovenants.
UsingthecurrentyieldonacomparableTreasury,theriskpremiumcanthenbecalculated.
Thefinalstepforthegroupistoaddressapotentialcapitalinvestment.Theinterestratewillbederived
fromtheinformationoftheshadowfirm;howeverthedetailsoftheprojectareentirelyuptothediscretion
ofthegroup.Studentsshouldbeencouragedtogetcreative,asthisisthefirmtheywillbelivingwithfor
anothertwomonths.

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Part3

Integrative Case 3: Encore International

Suggested Answers to Opener in Review Questions

Answers to Review Questions

Suggested Answer to Focus on Practice Box:

Suggested Answer to Focus on Ethics Box:

Answers to Warm-Up Exercises

$1,200 $1,500 $850

b. (0.05700$1,000) $977.08$57.000 $977.080.05835.83%

$50 [($1,000 $900) 3]

$60 [($500 $560) 12]

Evaluating Annie Heggs Proposed Investment in Atilier Industries Bonds

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