Chapter 5 CFIN5

Chapter 5 Solutions

1,000($29-$28)+1,000(4 × 0.10) $1.40

5-1 Return= = =0.05=5.0%
1,000($28) $28

40($9-$10)+40(0.50) -$0.50
5-2 Return= = =-0.05=-5.0%
40($10) $10

($44-$42)+2(0.05) $2.10
5-3 Return= = =0.05=5.0%
$42 $42

$156-$150+0 $6
5-4 Return= = =0.04=4.0%
$150 $150

1,000($45-$50)+1,000[($0.50)(8)] -$1
5-5 a. Return= = =-0.02=-2.0%
1,000($50) $50

1,000($45-$50)+1,000[($0.50)(4)] -$3
b. ReturnYear 1 = = =-0.06=-6.0%
1,000($50) $50

1,000($45-$45)+1,000[($0.50)(4)] $2
ReturnYear 2 = = =0.044=4.4%
1,000($45) $45

200($32-$28)+200[($0.60+$0.60+$0.60] $5.80
5-6 a. Return= = =0.207=20.7%
200($28) $28

200($26-$28)+200($0.60) -$1.40
b. ReturnYear 1 = = =-0.05=-5.0%
200($28) $28

200($28-$26)+200($0.60) $2.60
ReturnYear 2 = = =0.10=10.0%
200($26) $26

200($32-$28)+200($0.60) $4.60
ReturnYear 3 = = =0.164=16.43%
200($28) $28

5-7 Remember that the bonds’ yields represent the averages of the expected one-year interest rates for the
remaining lives of the bonds. Thus, the one-year interest rates for Year 2 and Year 3 can be computed as
follows:
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Chapter 5 CFIN5

Yield on 2-Year bond: (R1 + R2)/2

(4.0% + R2)/2 = 5.0%

R2 = 2(5%) – 4% = 6.0%

5-8 rRF1 = 1.0%; rRF2 = 0.9%; rRF3 = 0.8%

Remember that the bonds’ yields represent the averages of the expected one-year interest rates for the
remaining lives of the bonds. Thus, the one-year interest rates for Year 2 and Year 3 can be computed
as follows:

a. rRF2 averages 0.9% for two years. Thus, R2 in Year 2 is:

1.0%+R2
0.9%= R2 = 0.9%(2) – 1.0% = 0.8%
2

b. rRF3 averages 0.8% for three years. Thus, R3 in Year 3 is:

1.0%+0.8%+R3
0.8%= R3 = 0.8%(3) – (1.0% + 0.8%) = 0.6%
3

5-9 Remember that the bonds’ yields represent the averages of the expected one-year interest rates for the
remaining lives of the bonds. Thus, the one-year interest rates for Year 2 and Year 3 can be computed as
follows:

a. Year 2 interest rate: (0.4% + R2)/2 = 0.8%

R2 = 2(0.8%) – 0.4% = 1.2%

b. Year 3 interest rate: (0.4% + 1.2% + R3)/3 = 1.1%

R3 = 3(1.1%) – 0.4% – 1.2% = 1.7%

Alternative solution: We can multiply the yield by the number of years to maturity because we know
that the yield is an average that is computed by dividing the sum of the one-year rates by the number
of years to maturity. In other words, to attain an average of 1.1% for a three-year bond, the total of the
three one-year interest rates must equal 3.3% = 3(1.1%), because 1.1% = (Sum of the three one-year
rates)/3. The same can be done for the two-year yield. As a result, the one-year interest rate in Year
3 can be computed as follows:

Year 3 interest rate = 3(Three-year yield) - 2(Two-year yield)

= 3(1.1%) – 2(0.8%) = 1.7%

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accessible website, in whole or in part.
Chapter 5 CFIN5

5-10 Because the bonds’ yields represent the averages of the expected one-year interest rates for the remaining
lives of the bonds, the one-year interest rates for Year 6 and Year 7 can be computed as follows:

Year 6 interest rate = 6(2.9%) – 5(3.1%) = 17.4% – 15.5% = 1.9%

Year 7 interest rate = 7(2.6%) – 6(2.9%) = 18.2% – 17.4% = 0.8%

We can multiply the yield by the number of years to maturity because we know that the yield is an average
that is computed by dividing the sum of the one-year rates by the number of years to maturity. In other
words, to attain an average of 2.9% for a six-year bond, the total of the six one-year interest rates must
equal 17.4% = 6(2.9%), because 2.9% = (Sum of the six one-year rates)/6.

5-11 Because the bonds’ yields represent the averages of the expected one-year interest rates for the remaining
lives of the bonds, the one-year interest rates for Year 3 and Year 4 can be computed as follows:

Year 3 interest rate = 3(1.4%) – 2(1.2%) = 4.2% – 2.4% = 1.8%

Year 4 interest rate = 4(1.9%) – 3(1.4%) = 7.6% – 4.2% = 3.4%

We can multiply the yield by the number of years to maturity because we know that the yield is an average
that is computed by dividing the sum of the one-year rates by the number of years to maturity. In other
words, to attain an average of 1.9% for a four-year bond, the total of the four one-year interest rates must
equal 7.6% = 4(1.9%), because 1.9% = (Sum of the four one-year rates)/4.

5-12 rRF = r* + IPn = 3% + IPn, where IPn is the average annual inflation rate over n years.

Given: r* = 3.0%; Year 1 Inflation = 1.4%; Year 2 Inflation = 1.8%; Year 3 Inflation = … = Year ∞
Inflation = 2.0%

a. One-year bond: rRF = 3.0% + 1.4% = 4.4%

b. Five-year bond: rRF = 3.0% + (1.4% + 1.8% + 2.0% + 2.0% + 2.0%) = 3.0% + 1.84% = 4.84%

c. 10-year bond: rRF = 3.0% + [1.4% + 1.8% + 8(2.0%)] = 3.0% + 1.92% = 4.92%

5-13 rRF = r* + IPn = 2% + IPn, where IPn is the average annual inflation rate over n years.

IPn = Avg. inflation = (Infl1 + Infl2 + … + Infln)/n

We know that Infl1 = Infl2 = 1.5%. Therefore, IP1 = IP2 = 1.5%

rRF1 = rRF2 = 2% + 1.5% = 3.5%.

rRF3 = rRF1 + 0.5% = 3.5% + 0.5% = 4%. But,

rRF3 = r* + IP3 = 2% + IP3 = 4%, so IP3 = 4% - 2% = 2%

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Chapter 5 CFIN5

We also know that inflation is constant after Year 2. Thus, we can set up this table:

Year r* Inflation Average inflation = IPn rRF = r* + IPt

1 2% 1.5% 1.5%/1 = 1.5% 3.5%
2 2 1.5 (1.5% + 1.5)/2 = 1.5 3.5
3 2 IP3 (1.5% + 1.5% + Infl3)/3 = IP3 4.0%, so IP3 = 4% - 2% = 2%

IP3 = (1.5% + 1.5% + Infl3)/3 = 2%

Infl3 = 3(2%) – 3% = 3%

Thus, Infl3 = Infl4 = … = Infl∞ = 3.0%

5-14 We know the following:

Year One-Year Rate

2017 2.2%
2018 1.8
2019 2.9

a. Yield on a two-year bond = (2.2% + 1.8%)/2 = 2.0%

b. Yield on a three-year bond = (2.2% + 1.8% + 2.9%)/3 = 2.3%

5-15 We know the following:

Year One-Year Inflation Rate

2017 2.1%
2018 1.5
2019 0.9

rRF = r* + IPn = 2% + IPn, where IPn is the average annual inflation rate over n years.

a. IP1 = (2.1%)/1 = 2.1%; thus, rRF = 2.0% + 2.1% = 4.1%

b. IP2 = (2.1% + 1.5%)/2 = 1.8%; thus, rRF = 2.0% + 1.8% = 3.8%

c. IP3 = (2.1% + 1.5% + 0.9%)/3 = 1.5%; thus, rRF = 2.0% + 1.5% = 3.5%

Alternative Solution:

Year r* One-Year Inflation Rate rRF

2017 2.0% 2.1% 4.1%
2018 2.0 1.5 3.5
2019 2.0 0.9 2.9

a. One-year bond yield = 4.1%

b. Two-year bond yield = (4.1% + 3.5%)/2 = 3.8%

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Chapter 5 CFIN5

c. Three-year bond yield = (4.1% + 3.5% + 2.9%)/3 = 3.5%

5-16 We know the following:

Yield on a four-year bond = 2.5%; thus, the sum of the returns for the four-year period must equal 10.0%
= 2.5% x 4.

Year One-Yearl Rate

2021 4.5%
2022 2.3

a. Yield on a five-year bond = [2.5%(4) + 4.5%]/5 = (10.0% + 4.5%)/5 = 2.9%

b. Yield on a six-year bond = [2.5%(4) + 4.5% + 2.3%]/6 = (10.0% + 6.8%)/6 = 2.8%

5-17 Other than their yields, the only difference among the bonds is their terms to maturity. As a result, the
difference in the yields of these bonds must be the result of their MRPs. The nine-month bond does not
have an MRP, which means rRF = 2.3%. Thus,

MRP = (4.3% – 2.9%)/(10 – 3) = 1.4%/7 = 0.2% per year

Check:

1. Yield on a three-year bond = rRF + MRP3 = 2.3% +3(0.2%) = 2.9%

2. Yield on a 10-year bond = rRF + MRP10 = 2.3% +10(0.2%) = 4.3%

5-18 rRF = 3.2%

a. Because the only difference between Company F’s three-year bond and its seven-year bond is
the term to maturity, the difference in the yields of these two bonds must be the result of their
MRPs. Thus,

MRP = (5.8% – 5.0%)/(7 – 3) = 0.2% per year

b. Because there is no liquidity premium associated with Company F’s bonds, we know the following
exists:

Yield on Company F’s three-year bond = 5.0% = rRF + MRP + DRP

= 3.2% + 3(0.2%) + DRP

Thus, DRP = 5.0% – (3.2% + 0.6%) = 1.2%

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Chapter 5 CFIN5

Alternative Solution:

Yield on Company F’s seven-year bond = 5.8% = rRF + MRP + DRP

= 3.2% + 7(0.2%) + DRP

Thus, DRP = 5.8% – (3.2% + 1.4%) = 1.2%

5-19 rRF = 3.2%

a. Because the only difference between Bond T and Bond Q is their terms to maturity, the
difference in the yields of these two bonds must be the result of their MRPs. Thus,

MRP = (5.9% – 5.3%)/(8 – 5) = 0.2% per year

b. Because there is no liquidity premium associated with the two bonds, we know the following
exists:

Yield on Bond T (a five-year bond) = 5.3% = rRF + MRP + DRP

= 3.2% + 5(0.2%) + DRP

Thus, DRP = 5.3% – (3.2% + 1.0%) = 1.1%

Alternative Solution:

Yield on Bond Q (an eight-year bond) = 5.9% = rRF + MRP + DRP

= 3.2% + 8(0.2%) + DRP

Thus, DRP = 5.9% – (3.2% + 1.6%) = 1.1%

5-20 Based on the information that is given, we know the following relationships exist:

Bond yield = rRF + LP + DRP + MRP

Yield on one-year T-bond = 2.4% = rRF

Yield on GM’s one-year bond = 4.8% = rRF + LP + MRP +DRP

= 2.4% + 0.3% + 0.0% + DRP

Thus, DRP = 4.8% - (2.4% + 0.3%) = 2.1%

Yield on GM’s five-year bond includes MRP = 4(0.15%) = 0.6%. Thus, the bond’s total return is:

r = rRF + LP + MRP +DRP = 2.4% + 0.3% + 0.6% + 2.1% = 5.4%

© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part.