Practice Set: bond and annuities with Solutions

A birds eye view of the course:

It is of importance to know the principles of valuation of different financial
instruments as investors and as companies. In this course we have especially focused
on valuation of Stocks and Bonds which are the main financing source of
corporations.
(komma ihg: Vad r det fr skyldighet fr fretag som obligations utfrdare?
Periodiska rnta betalningar. Vad r det fr skillnaderna mellan aktier och obligation?
Kolla slides p kapital 6: bond valuation)
We have learned how to make investment decisions based on the market expected
return on the project, and the projects internal rate of return, the so called NPV
method.
We get the market expected return of a firm ri through Capital Asset Pricing Model.
That is the firms cost of equity capital. The higher the risk, the higher the expected
rate of return of the company.
If the firm is not 100% equity financed, and has a debt-equity ratio of D/E, then, we
can calculate firms Weighted Average Cost of Capital (WACC). This is the cost of
the firms total capital. A company is expected to at least fulfil this expected return at
the end of the period. Otherwise the investor is better off investing in other equally
risky business with the expected return. This means the companys share price is
going to fall.
A loss making company has a high chance of bankruptcy. etc.

Question 1
A bond has a face value of $1000 with a time to maturity ten years from now. The yield to
maturity of the bond now is 10%.
a) What is the price of the bond today, if it pays no coupons?
b) What is the price of the bond if it pays annual coupons of 10%?
c) What is the price today if pays 8% coupon rate semi-annually?

Question 2
a) What is the value today of a $1000 bond, 8% coupon with annual coupon payments if
the time to mature is 2 years and YTM is 4%?
b) What is the relationship between the yield and the price of a bond? Make a graph of
the values calculated above, with prices on the horizontal line and yields on the
vertical.

Question 3
a) How can issuers of bonds protect themselves against unpredicted drops in the
interest rate?
b) How can buyers of bonds protect the future payments they have been
promised?
Question 4
What is a callable bond? Who gains from a call option? In what situation? What can we say
about the prices and yields of two identical bonds if has a call option and the other has not?
Question 5
A credit card states that the interest rate is 14.95 % APR, but that the interest is charged
monthly. What is the monthly interest rate and what is the effective annual interest rate, or
the interest rate you will be charged if you use credit over 12 months?
Question 6
You have just decided to buy a sofa for 17000Skr. At the store the sales person offers you to
divide your payment over 12 months without interest . You will pay 17000/12 per month
starting next month plus an administrative fee of 35skr per month to be added to your
monthly bill. If your alternative is to use your credit card with an APR of 12% how much do
pay for sofa? (Hint: calculate the present value of the offer and compare it paying 17000
upfront today.

SOLUTIONS
Solution 1
a) The price today for a zero coupon bond is:
$385.54 = $1,000/(1.10)10 = 0.38554*1000
b) The answer is simple: if a bond pays 10% coupon rate and has a yield to maturity
10%, then the bond is selling at 100. Alternatively, you can calculate and verify it as
follows:
If the coupon rate is 10%, the annual coupon payment is 0.10*$1 000 = $100.

10%, 10
$100
.
The Present Value Annuity Factor for 10% interest and 10 periods is

1
10

10

0.10 0.10 1.1

3.8554 6.61446

10

1
0.10

2.5937

The present value of the coupon payments is PVAF*C = 6.61446*$100= $614.46

The present value of the Face Value is

$
.

$385.54.

The price of the bond today is 614.46 + 385.54=1000.

This is precisely 1000. (think about the principle: if coupon rate is lower than the
yield to maturity, then the bond is selling at a discount; if the coupon rate is higher
than the yield, the bond is selling at a premium)
c) Now the coupon rate is 0.08/2 = 0.04 semi-annually. Meaning coupon payment
0.04*1000= 40 every six months. For a period of 10 years we talk about 10*2 = 20
periods.
5% ,20

1000

, 40$
1

5%, 20

0.10
2

$1000
1
1
$40 0.4564 $1000
1.05
1
12.4622 $40 0.3769 $1000 498.49 376.89
$875.38

$40

Solution 2
a) Apply the appropriate formula, annual coupons and compounding, use the formula for the
present value annuity factor and the present value of the face value, to get the valuation
formula for the bond price today (t=0),

1
1

For r = 4% and T=2, we get first,

1
0.04

1
0.04 1

0.04

25

1
0.04 1.0816

25

231114

1.1861

This factor should be multiplied with the coupon, which is 0.08*1 000 = 80. This
gives you the present value of the coupon payments, C*PVAF = 150.89.
Next calculate the present value of the face value,
1000
1000
1000
1
1.04
1.0816
Finally put the two together,
150.89

924.57

924.57

1075.46

to find that, r = 4%, PVAF = 1.8861, P = $1 075.46

a) The graph should show that there is a convex and inverse relationship between prices
and yield (and thus market interest rates). The convexity means that an increase in the
interest rate results in a proportionally smaller fall in the price. If market interest rates
go up, bond prices will fall and if interest rates go down prices will increase. If you
hold bonds you typically gain from interest rates going down.

b) Par refers to Par Value, which is the same as Face Value (nominellt vrde p
svenska). Selling at Par means the price is equal (or approximately equal) to the Par
value. Selling above Par (or at a premium) means that the price is above the Par
value. Selling below par (or at a discount) means that the price of the bond is below
the par value. Typically, when a bond is issued, the coupon rate is set equal the par
value, meaning that the bond will sell at par during the first day of trading.

Solution 3
Define: Indenture, Callable bonds
Both issues are solved by putting restrictions in the indenture. When market interest
rate drops, the bond is having a higher interest expense than it can obtain now. To
avoid such scenario, companies can issue callable bonds, which allows them to buy
back the bonds at a specific price before a specific period in time. Thus a voiding
paying a higher than market interest rate through the life of the bond.
Bondholders are protected by paragraphs in the indenture against mergers, restrictions
on dividends, etc.
Solution 4
Bond with a call option is good for the issuer if interest rates fall. The bond with a call option
should sell at a lower price because the call provision is more valuable to the firm, not for the
holder of the bond. Investors pay less for a callable bond compared to the non-callable bond.
Therefore, the yield to maturity should be higher on a callable bond. (think about the opposite
scenario: a convertible bond where the holder has a call option to convert the bond to shares)

Solution 5
The monthly rate is 0.1495/12 = 0.0125. This is the rate you will be charged per month.
The effective annual rate is 1

1.0125

1.1602

That is 16,02 % effective interest p.a, (Not including any additional fees). This is the interest
you will have to pay if use your credit over a year.

Question 6

This is an annuity. You will pay 17000/12 = 1416.67 plus the fee 35 each month,
giving monthly payments of 1451.67.
Interest is 12% p.a., meaning 0.12/12 = 0.01 monthly.
The present value annuity factor is for 12 payments (periods) and 1% equal to
11.2551.
Thus the present value is PVAF * C = 11.2551*1451.67 = 16 338.65
The difference is 17 000-16 338.65 = 661.35 to your advantage since you agreed on
the initial price. However, you might to ask for a discount if you pay upfront in cash.
(That is if you have the cash of course)