Besley: Chapter 7 Homework #4 Pg. 324 7-1 Pg. 325 7-7 Pg. 328 7-14

Pg. 324 7-1 Suppose Ford Motor Company sold an issue of bonds with a ten-year maturity, a $1,000 par value, a ten percent coupon rate, and semiannual interest payments. Two years after the bonds were issued, the going rate of interest on bonds such as these fell to 6%. At what price would the bonds sell. Bond Value = INT(PVIFA3%,16) + M(PVIF3%,16) = 50(12.5611) + 1,000(0.6232) = $1,251.26

Pg. 324 7-1 Suppose that, two years after the initial offering, the going interest rates had risen to 12%. At what price would the bond sell? Input: 16 6 50 1,000 N I/Y PV PMT FV Output: 898.94

Pg. 324 7-1 Suppose that the conditions in part (a) existed – that is, interest rates fell to six percent two years after the issue date. Suppose further that the interest rate remained at six percent for the next eight years. Describe what would happen to the price of the of the Ford Motor Company bonds over time. The price of the bond will decline toward $1,000.

Page 325 7-7 In January of 1994, the yield on AAA rated corporate bonds averaged about 5%; by the end of the year the yield on these same bonds was about 8% because the Federal Reserve increased interest rates six times during the year. Assume IBM issued a 10-year, 5% coupon bond on January 1, 1994. On the same date, General Motors issued a 20-year, 5% coupon bond. Both bonds pay interest annually. Also assume that the market rate on similar risk bonds was 5% at the time the bonds were issued.

Page 325 7-7 Compute the market value of each bond at the time of issue. Both bonds would have sold at par since the coupon rate was equal to the original YTM. N=10; I=5%; PMT=50; FV=1,000 Compare the market value of each bond one year after issue if the market yield for similar risk bonds was 8% in 1/1/95. VIBM=50(6.2469)+1,000(0.5002) = $812.55 VGM=50(9.6036)+1,000(0.2317) = $711.88

Page 325 7-7 Compute the 1994 capital gains yield for each bond. Capital GainsIBM=(812.55-1,000)/1,000=-18.75% Capital GainsGM=(711.88-1,000)/1,000=-28.81% Compute the current yield for each bond in 1994. The current yield for both bonds was $50/1,000 = 5% Compute the total return each bond would have generated for investors in 1994. Total ReturnIBM=5%+(-18.75%) = -13.75% Total ReturnGM=5%+(-28.81%) = -23.81%

Page 325 7-7 If you invested in bonds at the beginning of 1994, would you have been better off to have held long-term or short-term bonds? Explain why. The IBM bond, which has the shorter ter to maturity, lost less than the GM bond. The price of the shorter-term bond changes less with each change in interest rates. Assume interest rates stabilize at the January 1995 rate of 8.5%, and they stay at this level indefinitely. What would be the price of each bond on January 1, 2000 after six years from the date of issue have passed? Described what should happen to the prices of these bonds as they approach their maturities. VIBM = $885.35; VGM = 719.65 At maturity, the values of both bonds will be equal to $1,000. The closer the maturity value, the quicker the market value will approach its face value.

Page 328 7-14 The Severn Company’s bonds have four years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 9%. Compute the approximate yield to maturity for the bonds if the current market price is either (1) $829 or (2) $1,104. Approx. YTM = INT+[(M-Vd)/N]/[2Vd+M]/3 Vd=$829 Approx YTM=132.75/886 = 14.98 Vd=$829 Approx YTM=64/1,069.33 = 5.99% Would you pay $829 for one of these bonds if you thought that the appropriate rate of interest was 12%-that is, if kd=12%. Explain. Vd =$90(PVIFA12%,4)+$1,000(PVIF12%,4) =$90(3,0373+1,000(0.6355) = 908.86 If the bond was selling at $829, it would be a bargt.