CONNECT WITH LEARNSMART FOR BODIE: ESSE
CONNECT WITH LEARNSMART FOR BODIE: ESSE
11th Edition
ISBN: 2819440196239
Author: Bodie
Publisher: MCG
Question
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Chapter 10, Problem 35PS

a(ii)

Summary Introduction

To examine:

Why YTM of par bond is higher than the YTM of the discount bond where,

The first bond was issued at a deep discount with an interest rate4%with a price of$580and YTM is8.4%.

The second bond was issued at par with a coupon rate of8.75%

Introduction:

The yield to maturity symbolized as YTM − it is regarded as the single interest rate which equalizes the present value of a security's cash flows to that of its price.

a(ii)

Expert Solution
Check Mark

Answer to Problem 35PS

There is a gain only5%by increasing in price up to$1050.

Explanation of Solution

Given Information:

The first bond was issued at deep discount and the second was issued at par.

If the bond was issued at par then it is more beneficial for the bondholder because the rate of this bond is less than or equal to market yields and price of this bond would also be below the call price i.e.$1050.

So, there is a gain only5%by increasing in price up to$1050.

Summary Introduction

(b)

To calculate:

Total gain on both bonds if price subsequently falls down in the next two year where,

The first bond was issued at a deep discount with an interest rate of4%with price of$580and yield to maturity is8.4%.

The second bond was issued at par with a coupon rate of8.75%

Introduction:

The yield to maturity symbolized as YTM − it is regarded as the single interest rate which equalizes the present value of a security's cash flows to that of its price.

Expert Solution
Check Mark

Answer to Problem 35PS

The deep discount bond was providing higher return to investor.

Explanation of Solution

The present value of bond issued at par is

  PV of Bond issue at par=t=120PMT1+r1+FV1+r20=t=120$87.51.08751+$10001.087520=$1000

The present value of bond deeply discount bond is

  PV of Deep Discount Bond=t=120PMT1+r1+FV1+r20=t=120$401.0841+$10001.08420=$580.55

If YTM is decrease by4%for both bonds in next two years then

The present value for bond issue at par for remaining18years is

  PV of Bond=t=118PMT1+r1+FV1+r18=t=118$87.51.04751+$10001.047518=$1476.85

The present value of bond deeply discount bond for remaining18years is

  PV of Deep Discount Bond=t=118PMT1+r1+FV1+r18=t=118$401.0441+$10001.04418=$950.97

Total coupon income on bond issued at par for two year is

  Income=$87.5+$87.5=$175

Total coupon income on deeply discount bond for two year is

  Income=$40+$40=$80

Total return on bond issued at par is

  Return=$1476.85$1000+$175$1000=65.19%

Total return on deeply discount bond is

  Return=$950.97$580.55+$80$580.55=77.59%

The deeply discount bond is given higher return to the investor.

Summary Introduction

(c)

To determine:

Implicit call protection provided by a deeply discount bond.

Introduction:

Bonds frequently are issued in call protection with a period.The selling price of a deeply discount bond is lesser than the call price which is implicit call protection.

Expert Solution
Check Mark

Answer to Problem 35PS

The bond was issued with implicit call protection for compensating and giving an offer to the investor.

Explanation of Solution

For reducing the cost of debt on calling the bond before maturity, the bond was issued with call protection by the issuer. Forthis, the company is also giving a premium on call to bondholders for compensating the investor.

The selling price of a bond is lower from the call price so this bond was issued with implicit call protection for giving an offer to the investor.

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