BOND VALUATION
Robert Black and Carol Alvarez are vice presidents of Western Money Management and
codirectors of the company’s pension fund management division. A major new client, the California League of
Cities, has requested that Western present an investment seminar to the mayors of the represented cities.
Black and Alvarez, who will make the presentation, have asked you to help them by answering the following
questions:
1-What are a bond’s key features?
2-What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?
3-How is the value of any asset whose value is based on expected future cash flows determined?
4-What would happen to the values of the 7%, 10%, and 13% coupon bonds over time if the required return
remained at 10%? (Hint: With a financial calculator, enter PMT, I/YR, FV, and N; then change (override) N to
see what happens to the PV as it approaches maturity.)
5-What is the yield to maturity on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887.00?
That sells for $1,134.20? What does the fact that it sells at a discount or at a premium tell you about the
relationship between rd and the coupon rate?
6-What are the total return, the current yield, and the capital gains yield for the discount bond? Assume that it
is held to maturity, and the company does not default on it. (Hint: Refer to footnote 6 for the definition of the
current yield and to Table 7.1.)
7-What is price risk? Which has more price risk, an annual payment 1-year bond or a 10-year bond? Why?
8-What is reinvestment risk? Which has more reinvestment risk, a 1-year bond or a 10-year bond?
9-Suppose for $1,000 you could buy a 10%, 10-year, annual payment bond or a 10%, 10-year, semiannual
payment bond. They are equally risky. Which would you prefer? If $1,000 is the proper price for the semiannual
bond, what is the equilibrium price for the annual payment bond?
10-Suppose a 10-year, 10% semiannual coupon bond with a par value of $1,000 is currently selling for
$1,135.90, producing a nominal yield to maturity of 8%. However, it can be called after 4 years for $1,050.
a-What is the bond’s nominal yield to call (YTC)?
b-If you bought this bond, would you be more likely to earn the YTM or the YTC? Why?
