Problem Set 2

Corporate Finance, Sections 301 and 302

Due Thursday, September 15
1. (a) Suppose that you have purchased a 3-year zero-coupon bond with face value of
$1000 and a price of $850. If you hold the bond to maturity, what is your annual
return?
(b) Now suppose you have purchased a 3-year bond with face value of $1000, a 7%
annual coupon, and a price of $975. Is the yield to maturity greater or less than
the annual return you computed for the bond in part (a)?
2. Suppose you bought a five-year zero-coupon Treasury bond for $800 per $1000 face
value. Answer the following questions:
(a) What is the yield to maturity (annual compounding) on the bond?
(b) Assume the yield to maturity on comparable bonds increases to 7% after you
purchase the bond and remains there. Calculate your holding period return
(annual return) if you sell the bond after one year.
(c) Assuming yields to maturity on comparable bonds remain at 7%, calculate your
holding period return if you sell the bond after two years.
(d) Suppose after 3 years, the yield to maturity on comparable bonds declines to
3%. Calculate the holding period return if you sell the bond at that time.
(e) If the yield remains at 3%, calculate your holding period after four years.
(f) After five years.
(g) What explains the relationship between holding period returns calculated in (b)
through (f) and the yield to maturity in (a)?
3. Assume the government issues a semi-annual bond that matures in 5 years with a
face value of $1,000 and a coupon yield of 10 percent.
(a) What would be the price if the yield to maturity (semi-annual compounding) on
similar government bonds were 8%?
(b) What price would you be willing to pay for such a bond if the yield to maturity
(semi-annual compounding) on similar 5-year government bonds were 12%?
(c) Suppose you held the bond in (a) for 6 months, at which time you received a
coupon payment and then sold the bond for a price of 104 (per $100 of face
value). What would be the (annualized) holding period return?
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4. For each of the bonds and reinvestment rates listed below calculate the amount of
money accumulated at the end from a $1000 initial investment. Assume annual
compounding.
(a) Invest $1000 in a 5-year zero coupon bond with a yield to maturity of 9 percent.
(b) Buy a 5-year 9% annual coupon bond at par ($1000) and reinvest the annual
coupons at 9%.
(c) Same as (b) but reinvest the annual coupons at 12%.
(d) Same as (b) but reinvest the annual coupons at 6%.
(e) For (a) through (d) calculate the holding period return. What can you conclude
about the relationship between yield to maturity and holding period return?
5. Consider the following two bonds:
Bond
A
B

Price

Cash
Yr1
$1059.19 100
$1041.02 90

Flows
Yr2
1100
1090

(a) Find the prices of the one and two-year zero-coupon bonds (per $100 of face
value) implicit in the prices of these coupon bonds.
(b) Using your answers from part (b), compute the yields to maturity on the one
and two-year zero coupon bonds (this is the zero-coupon yield curve).
6. Bond A is a zero-coupon bond paying $100 one year from now. Bond B is a
zero-coupon bond paying $100 two years from now. Bond C is a 10% coupon bond
that pays $10 one year from now and $10 plus the $100 principal two years from now.
The yield to maturity on bond A is 10%, and the price of bond B is $84.18.
Assuming annual compounding, answer the following:
(a) What is the price of bond A?
(b) What is the yield to maturity on bond B?
(c) What is the implied forward rate f1,1 between years one and two?
(d) What is the price of bond C?
(e) You are working for a large institutional investor. Another firm offers to lend
your firm $1 million between one year from now and two years from now. at a
rate of 8.5%. Do you accept?
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(f) Using the rates in (a) and (b), calculate the NPV of a project that pays out
$840 one year from now, $340 two years from now, and costs $1000 today.
Assume the risk of these cash flows is the same as the risk of the bond. Using
the NPV rule, do you accept this project?
7. Suppose current spot rates (yields to maturity on zero-coupon bonds) are as follows:
r1 = 4%, r2 = 4.25%, r3 = 5%, and r4 = 5.20%. Here rt is the yield-to-maturity on
the t-year zero coupon bond.
(a) What is the rate that you can lock in now for lending between years 3 and 4?
Briefly describe the transaction that allow you to lend at this rate.
(b) What is the rate that you can lock in now for lending between years 1 and 4?
Briefly describe the transaction that allow you to lend at this rate.
(c) What is the rate you can lock in now for lending between years 0 and 3? Briefly
describe the transaction that allow you to lend at this rate.