ABC Company is considering investing in either of the two outstanding bonds. Both bonds have Rs.2,000 par values and 10% coupon interest rates and pay annual interests. Bond A has exactly 3 years to maturity, and bond B has 5 years to maturity.
a) Calculate the value of bond A if the required rate of return is 14%.
b) Calculate the value of bond B if the required rate of return is 14%.
c) If ABC wants to minimize the Interest Rate Risk, which bond should be purchased? Why.
NPV Bond Pricing Equation: vu handout page#123
Bond Price = PV = C1/ (1+rD) + C2/ (1+rD) t2+ C3 / (1+rD)t3 +….. + PAR / (1+rD)n3
Where
Pv = Bound value
C= Coupon payment Pa = 2000*10.100= 200 C1 ...C2 For each year
rD= Required rate of return = 14%=0.14
PAR = Par value or face value= 2000
Maturity period
Bound A = t 3 n3
Bound B = t 5 n5
Idea Solution Of Question 1
Question stock beta#1
Vu handout page#105
Average Required ROR for all rational investors in an Efficient Market can be estimated using the CAPM Theory: Beta and Risk Free Rate of Return.
Total Rate of Return (ROR) for Single Stock = Dividend Yield + Capital Gain. GORDON’S FORMULA FOR COMMON STOCK PRICING OR VALUATION USES REQUIRED RETURN r = DIV/Po + g. In Efficient Markets, Price of Stocks is based on Market Risk (or Beta). We can formulate the required rate of return in terms of Beta risk so how can we use beta coefficient to calculate the required rate of return for the average investor in the market. The answer to it is the
Vu handout page # 114
Po* = DIV1 / [ (rRF + (rM - rRF ) βA ) - g]
Where
Po*=80
DIV1= 5
g= 7%
rRF = 6%
rM = 10%
βA ) ?
Now put the values and get answer which is = βA 1.8125
We know that:
PV = C1/ (1+rD) + C2 /(1+rD) 2 + C3 / (1+rD)3 + C4/(1+rD)4 + C5/(1+rD)5+ PAR / (1+rD)5PV = 200/ (1+ 0.14) + 200/(1+0.14)2 + 200/(1+0.14)3 + 200/ (1+0.14)4 + 200/(1+0.14)5
+2000/(1+0.14)5
PV = (200/1.14) + (200/ 1.2996) + (200/1.4815) + (200/1.6889) + (200/1.9254) + 2000/1.9254
PV = 175.4386 + 153.8935 + 134.9983 + 118.4203 + 103.8745 + 1038.7452
PV = 1725.3704 (Bond B)
c) If ABC wants to minimize the Interest Rate Risk, which bond should be purchased? Why?
Answer:
When interest rate rises, bond price falls. Inversely, when interest rate falls, bond price rises. The longer the maturity period, the greater is the interest rate risk.
According to LAWARENCE J. GITMAN FINANCIAL MANAGEMENT (12th EDITION) interest rate risk is the market interest rate fluctuation that directly affects the bond’s value that have constant coupon payment, to reduce the fear of market interest risk diversify the portfolio as it can be spread and chose the bond with shorter duration.
So, ABC should purchase bond A having the shorter maturity period than bond B.
Here price of bond A is 1814.3135 is greater than the price of bond B, which is 1725.3704.
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