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ASSIGNMENT 2

Due: Friday, beginning of second tutorial class


(Note: unless otherwise stated, all interest rates are annual rates, compounded
annually)
Question 1:
Your junior analyst reports the following prices (all bonds are $1000 face value two-
year maturity bonds with annual coupons):
Bond Counon Rate Price
A 6% $964.33
B 10% $1025.66
C 12% $1.071.33
I
a) Why do you ask your junior analyst to check her numbers? (HINT: part a) is
NOT an IRR question)
b) If the numbers are right what should you do?
c) Calculate the IRR for each of the bonds.
d) Why might IRR not be useful in comparing relative bond prices?
Question 2:
The current price of a3-year zero coupon bond with $1000 face value is $840. The
price of a3-year bond with a6%annual coupon and a$1000 face value is $1000.
What would be the price of a3-year 10%annual coupon bond with a$1500 face
value?
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Question 3:
Assume that the yield curve is always flat (i.e. yields of all maturities arethe same and
change together when the yield curve shifts).
a) What is today's duration (in years) ofa 12%semi-annual coupon bond (face value
$1,000, coupon payments $60 every six months), with amaturity date 1year from
now? The bond was bought at $1,019.23 exactly six months ago (just after a
coupon payment), and if the bond were sold today, then the selling price would
result in asemi-annually compounded holding period return of 8%per
year.(HINT: compute the yield on the bond first and then compute the duration.
For the yield, you will need today's price)
b) What will be the duration (in years) of the bond six months from now if the yield
curve remains where it is today? How about if the yield curve shifts down by
1.5%?
c) If the yield curve shifted back to the level that it was six months ago, would
today's price be higher than, lower than, or equal to its original value of$I,019.23.
NB: An (annually compounded) interest rate of 10%per annum means 10%is paid
every 12months. A semi-annually compounded interest rate of 10%per annum means
5%is paid every 6months. Which would you prefer to be the recipient of: asemi-
annually compounded rate of 10%per annum or an annually compounded rate of
10%?
Question 4:
a) The current price of a3-year bond with $1,000 face value is $1,030. What must be
its (semi-annual) coupon payment if the current semi-annually compounded YTM
is 8%per year? What would it be if the annually compounded yield on bonds were
8%?
b) Here is apicture of the zero coupon yield curve (between the labelled points, the
yield curve consists of straight lines!). What is the price of a3year, 10%(annual)
coupon bond?
10%
8%
" " C
6%
-~
--
4%
~
2%
0%
0
8%
. . . . . .
7%
6%
I I I
5 10 1
Y e a r s
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Question 5:
ABC Inc. currently manufactures and sells 10million widgets per year. It is
considering the outsourcing of the widget production to XYZ Corp, adiversified
manufacturing firmthat makes many different products. The tax rate is 40% (ABC
and XYZ are both profitable enough to use all possible tax shields fully).
The current situation: Widgets arebeing sold for $3.00 per unit. Widgets are
produced at amaterial cost of$1.50 per unit, labour cost of $0.20 per unit, and total
fixed costs (selling, general and administrative expenses) for the widget division of
$0.5 million per year. Depreciation of the existing widget machinery is $5million per
year for another 3years (at which point the machines would be worth $0 on the
books). There are 1million widgets in ABC's inventory at all times. In 5years from
now, ABC's patent on the widgets will run out and there will no longer be profits in
the industry. Hence, ABC will get out of the widget market at that time (its machines
will have no more market value at that time). Total interest expenses for ABC are $4
million per year.
Outsourcing Project: The widget machinery could be sold for $7million today.
Future widgets could be purchased fromXYZ Corp. for $2.00 per unit for the next 5
years. All inventories could be eliminated (at a 10%discount to get rid of all of it at
once), as XYZ would deliver widgets directly to ABC's customers.
All cash flows occur at the end of the year (except the outsourcing proceeds from
selling machines and inventories, which occur right away).
Cost of Capital: The project would be entirely financed with debt. ABC's recently
issued $1,000 face value zero-coupon bonds with 7.5remaining years to maturity are
trading at $600 (You should not include the tax shields on debt).
Is the outsourcing project agood idea for ABC? Answer the following questions to
demonstrate your understanding of the issues:
1) What are the cash flows associated with the outsourcing project?
2) What is the applicable cost of capital?
3) Calculate the NPV of the Outsourcing Project.
4) Suppose the cost of capital was higher than the number you calculated in 2).
Would that increase of decrease the NPV of the project? Without calculations,
explain briefly.
You should assume that all tax shields are realisable in the year they occur.
Clearly state all assumptions you make (marks will be awarded for both the correct
answer and assumptions made).