Chapter 4

Answers to Concept Review Questions

1. Managers need to understand how bonds and stocks are priced because (1) firms regularly
issue stocks and bonds to raise money for investment (2) understanding how securities are
priced is helpful when conducting an acquisition or a divestiture, () the stock price is an
ob!ective signal of how managers are performing, and (") finance theory teaches that the goal
of the manager should be to ma#imi$e the firm%s stock price.
&. 'he coupon rate equals the annual coupon payment divided by par value. 'he coupon yield
equals the annual coupon payment divided by the bond%s market price.
(. ) bond sells at a discount when the bond%s coupon rate is lower than the market%s required
rate of return on the bond.
11. )n issuer benefits from an option to call a bond, because such an option allows the issuer to
lock in a more favorable interest rate if rates should fall.. 'he option to convert bonds into
common stock benefits bondholders. *nce the stock price rises high enough, the value of the
bonds starts to behave like the stock%s value+the prices start to rise. ,o convertible bonds
offer investors some minimal level of return plus a lot of upside potential.
1. 'he price of a 'reasury note quoted as -./10 is -. 1012 percent of par value or 2-..12&.
Answers to End-of-Chapter Questions
Q4-1. 3hat is the relationship between the price of a financial asset and the return that investors
require on that asset, holding other factors constant4
A4-1. 5olding an asset%s cash flows constant, if investors pay a higher price for the asset, then
their return from holding the asset will be lower. 6n general, asset prices are inversely
correlated with returns.
Q4-2. 7efine the following terms commonly used in bond valuation/ (a) par value, (b) maturity
date, (c) coupon, (d) coupon rate, (e) coupon yield, (f) yield to maturity (YTM), and (g)
yield curve.
A4-2. 'he par value is the face value of principal amount that a bond repays when it matures. 6t
is usually 21,000 for corporate bonds. 'he maturity date indicates when a bond%s final
payment is due, and it signals the end of the bond%s life. 'he coupon is the dollar amount
of interest that a bond pays over a year. 'he coupon rate equals the coupon divided by the
par value. 'he coupon yield equals the coupon dividend by the market price of the bond.
'he 8'M is the discount rate that equates the present value of a bond%s cash flows to its
current market price, and it is a measure of the return that investors require on a particular
bond. 'he yield curve is a graph showing how interest rates vary with maturity for a
group of bonds having equal risk.
Q4-5. ) firm issues a bond at par value. ,hortly thereafter, interest rates fall. 6f you calculated
the coupon rate, coupon yield, and yield to maturity for this bond after the decline in
1
interest rates, which of the three values would be highest and which would be lowest4
9#plain.
A4-5. )s rates fall the bond%s price will rise. 'his does not affect the coupon rate, but it will
lower the coupon yield and the 8'M. :ecause the bond now sells at a premium, there is a
built;in capital loss for the investor who paid par value and holds the bond to maturity.
<ompensating for this loss is the fact that the bond%s coupon yield will be greater than the
8'M. ,o in order we have/
<oupon rate = coupon yield = 8'M
Q4-6. 'wenty;five years ago, the >.,. government issued thirty;year bonds with a coupon rate
of about eight percent. ?ive years ago, the >.,. government sold ten;year bonds with a
coupon rate of about & percent. ,uppose that the current coupon rate on newly issued
five;year 'reasury bonds is 2.& percent. ?or an investor seeking a low;risk investment
maturing in five years, do the bonds issued twenty;five years ago with a much higher
coupon rate provide a more attractive return than the new five;year bonds4 3hat about
the ten;year bonds issued five years ago4
A4-6. 'he 8'M on each of these bonds would be quite similar. 'he bonds paying an eight
percent coupon would trade at a significant premium, and the bonds paying a five percent
coupon would trade at a smaller premium. 'he premium that an investor would have to
pay to acquire either of these bonds would largely offset the higher coupon rates that they
offer, leaving the 8'M close to 2.& percent.
Q4-7. 7escribe how a bond%s interest rate risk is related to its maturity.
A4-7. @enerally speaking, interest rate risk increases with time to maturity.
Q4-8. 9#plain why municipal bonds can offer lower interest rates than equally risk corporate
bonds.
A4-8. 6nterest from muni bonds is e#empt from federal ta#es, so the pre;ta# interest rate offered
by a corporate bond has to be higher than the rate on a muni bond to compensate for the
higher ta#es investors must pay on corporate bond interest.
Q4-10. >nder the expectations theory, what does the slope of the yield curve reveal about the
future path of interest rates4
A4-10. >nder the expectations hypothesis, the slope of the yield curve indicates the direction of
future interest rate movements. ) positive slope indicates rising rates, and a negative
slope indicates falling rates.
Q4-11. 6f the yield curve is typically upward sloping, what would this imply about the long;term
path of interest rates if the e#pectations theory were true4
A4-11. 'his would imply that investors normally e#pect rates to rise.
2
Solutions to End-of-Chapter Problems
P4-3. ) 21,000 par value bond makes two interest payments each year of 2"& each. 3hat is the
bond%s coupon rate4
A4-3. -A B "&(2)11,000
P4-4. ) 21,000 par value bond has a coupon rate of eight percent and a coupon yield of nine
percent. 3hat is the bond%s market price4
A4-4. 'he annual coupon is 2.0. 'o find the price, solve 0.0- B 2.01C, C B 2.....-
P4-5. ) bond sells for 2-00 and offers a coupon yield of D.2 percent. 3hat is the bond%s annual
coupon payment4
A4-5. 2E12-00 B 0.0D2 so E B 2("..
P4-6. ) bond offers a coupon rate of & percent. 6f the par value is 21,000 and the bond sells for
21,2&0, what is the coupon yield4
A4-6. 2&0121,2&0 B 0.0" or "A.
P4-7. ) bond makes two 2"& interest payments each year. @iven that the bond%s par value is
21,000 and its price is 21,0&0, calculate the bond%s coupon rate and coupon yield.
A4-7. <oupon yield is 2-0121,0&0 B 0.0.&D or ..&DA. <oupon rate B -A.
P4-8. <alculate the price of a five;year, 21,000 par value bond that makes semiannual
payments, has a coupon rate of eight percent, and offers a yield to maturity of seven
percent. Fecalculate the price assuming a nine percent 8'M. 3hat general relationship
does this problem illustrates4
A4-8.
&. . 0"1 , 1
)
2
0D . 0
1 (
0"0 , 1
....
)
2
0D . 0
1 (
"0
)
2
0D . 0
1 (
"0
)
2
0D . 0
1 (
"0
C
10 2
=
+
+ +
+
+
+
+
+
=
<alculator/ G B 10 6 B .& CH B 1,0"1.&. CM' B "0 ?H B 1000
"" . -(0
)
2
0- . 0
1 (
0"0 , 1
....
)
2
0- . 0
1 (
"0
)
2
0- . 0
1 (
"0
)
2
0- . 0
1 (
"0
C
10 2
=
+
+ +
+
+
+
+
+
=
<alculator/ G B 10 6 B ".& CH B -(0."" CM' B "0 ?H B 1000
3hen the coupon rate is higher than the YTM, the bond sells at a premium, but when the
coupon rate is lower than the 8'M, the bond sells at a discount. 'his problem also illustrates
the general inverse relationship between bond prices and interest rates.
P4-9. ) 21,000 par value bond makes annual interest payment of 2D&. 6f it offers a yield to
maturity of D.& percent, what is the price of the bond4

A4-9. 'he bond will sell at par value or 21,000 because the bonds coupon rate (D&11000 B
D.&A) is equal to its 8'M. 'he idea here is that a bond%s market price equals par value if
yield to maturity is equal to the bond%s coupon rate.
P4-10. ) 21,000 par value bond pays a coupon rate of ..2 percent. 'he bond makes semiannual
payments, and it matures in four years. 6f investors require a ten percent return on this
investment, what is the bond%s price4
A4-10.
. . -"1 2
0& . 1
0"1 , 1
....
0& . 1
"1
0& . 1
"1
0& . 1
"1
C
. 2
= + + + + =
<alculator/ G B . 6 B & CH B -"1.. CM' B "2 ?H B 1000
P4-11. @riswold 'ravel 6nc. has issued si#;year bonds that pay 20 in interest twice each year.
'he par value of these bonds is 21,000 and they offer a yield to maturity of &.& percent.
5ow much are the bonds worth4
A4-11.
2( . 02& , 1
)
2
0&& . 0
1 (
00 , 1
...
)
2
0&& . 0
1 (
0
)
2
0&& . 0
1 (
0
C
12 2
=
+
+
+
+
+
=
<alculator/ G B 12 6 B 2.D& CH B 1,02&.2( CM' B 0 ?H B 1000
P4-12. :ennifer Iewelers recently issued ten;year bonds that make annual interest payments of
2&0. ,uppose you purchased one of these bonds at par value when it was issued. Fight
away market interest rates !umped, and the 8'M on your bond rose to si# percent. 3hat
happened to the price of your bonds4
A4-12
"0 . -2( 2
0( . 1
0&0 , 1
....
0( . 1
&0
0( . 1
&0
0( . 1
&0
C
10 2
= + + + + =
so the price fell by 2D.(0.
<alculator/ G B 10 6 B ( CH B -2(."0 CM' B &0 ?H B 1000
P4-13. 8ou are evaluating two very similar bonds. :oth mature in four years, both have a 21,000
par value, and both pay a coupon rate of ten percent. 5owever, one bond pays that
coupon in annual installments while the other makes semiannual payments. ,uppose you
will require a ten percent return on either bond. ,hould these bonds sell at identical prices
or should one be worth more than the other4 >se 9quations ".2 and ". and let r B 10A.
3hat prices do you obtain for these bonds4 <an you e#plain the apparent parado#4
A4-13. >sing equation ".2, the bond that pays annual interest will sell at par value, and using
equation "., the semiannual bond will also sell for par value. 6ntuitively, the bond that
makes semiannual payments should be worth more because it pays the same cash as the
other bond but it pays the cash a little sooner. 'he fact that 9quations ".2 and ". make it
seem as if the two bonds will both sell at par is a result of the fact that a 10A annual
discount rate is not equal to a &A semiannual discount rate. 'hat is, when we let r B 0.10
in 9quation "., we are really using an annual discount rate of 10.2&A. 6t is only because
we are applying a higher effective discount rate to the semiannual bond that it appears to
be !ust as valuable as the bond that pays annually.
"
P4-14. ) bond makes annual interest payments of 2D&. 'he bond matures in four years, has a par
value of 21,000, and sells for 2-D&.0. 3hat is the bond%s 8'M4
A4-14.
" 2
) r 1 (
0D& , 1
) r 1 (
D&
) r 1 (
D&
r 1
D&
0 . -D&
+
+
+
+
+
+
+
=
so r B 0.0.2& or ..2&A
<alculator/ G B " 6 B ..2& CH B ; -D&.0 CM' B D& ?H B 1000
P4-15. Iohanson H6 )dvisors issued 21,000 par value bonds a few years ago with a coupon rate
of seven percent, paid semiannually. )fter the bonds were issued interest rates fell, and
now with three years remaining before they mature, the bonds sell for 21,0&&.0.. 3hat
8'M do these bonds offer4
A4-15.
( 2
)
2
r
1 (
0& , 1
...
)
2
r
1 (
&
)
2
r
1 (
&
2
r
1
&
0. . 0&& , 1
+
+ +
+
+
+
+
+
=
and r B0.0& or &A
<alculator/ G B ( 6 B 2.& CH B ; 1,0&&.0. CM' B & ?H B 1000, r B 6 # 2A B 2.& # 2A B &A
P4-16. ) bond offers a si# percent coupon rate and sells at par. 3hat is the bond%s yield to
maturity4
A4-16. (A
P4-19. ,uppose investors face a ta# rate of "0 percent on interest paid by corporate bonds.
,uppose )));rated corporate bonds currently offer yields of about seven percent.
)ppro#imately what yield would )));rated municipal bonds have to offer to be
competitive4
A4-19. 'he after;ta# return on the corporate bonds would be ".2A JDA(1;"0A)K. ,ince muni;
bond interest is ta# free, municipal bonds could offer a ".2A yield and be competitive
with corporate bonds.
P4-20. 6nvestors face a ta# rate of percent on interest paid by corporate bonds. 6f municipal
bonds currently offer yields of si# percent, what yield would equally risky corporate
bonds need to offer to be competitive4
A4-20. 0.0(10.(( B 0.0- or -A.
P4-22. 3hat is the price of a $ero;coupon bond that has a par value of 21,0004 'he bond
matures in 0 years and offers a yield to maturity of ".& percent. <alculate the price one
year later, when the bond has 2- years left before it matures (assume the yield remains at
".& percent). 3hat is the return that an investor earns if they buy the bond with 0 years
remaining and sell it one year later4
A4-22. 1,0001(1.0"&)
0
B 22(D. 1,0001(1.0"&)
2-
B 22D-.02. 'he one;year return is therefore
(2D-.0212(D);1 B 0.0"& or ".&A. 'his is !ust the required return on the bond.
P4-23. ) 'reasury bond%s price is quoted as -./11. 3hat is the price of the bond if its par value
is 21,0004
&
A4-23. -. 1112 percent of par value or 2-.."".
P4-24. ) corporate bond%s price is quoted as 102.12. 6f the bond%s par value is 21,000, what is
its market price4
A4-24. 21,02.12
P4-25. ) one;year 'reasury security offers a " percent yield-to-maturity. ) two;year 'reasury
security offers a ".2& percent 8'M. )ccording to the expectations hypothesis, what is the
e#pected interest rate on a one;year security ne#t year4
A4-25. (1.0"2&)
2
B (1.0")(1Lr) so r B 0.0"& or ".&A
(