Unit 2 Assignment Chapter 4

4-8 Annuity Payment and EAR You want to buy a car, and a local bank will lend you $20,000. The loan would be fully amortized over 5 years (60 months), and the nominal interest rate would be 12%, with interest paid monthly. What is the monthly loan payment? What is the loans EFF%? Using a financial calculator, enter the following: N = 60, I/YR = 1, PV = -20000, and FV = 0. Solve for PMT = $444.89. EAR = 1
I NOM M
M

1.0

= (1.01)12 1.0 = 12.68%. Alternatively, using a financial calculator, enter the following: NOM% = 12 and P/YR =12. Solve for EFF% = 12.6825%. Remember to change back to P/YR = 1 on your calculator.

4-24

Required Lump-Sum Payment 7% To complete your last year in business school and then go through law school, you will need $10,000 per year for 4 years, starting next year (that is, you will need to withdraw the first $10,000 one year from today). Your rich uncle offers to put you through school, and he will deposit in a bank paying 7% interest a sum of money that is sufficient to provide the 4 payments of $10,000 each. His deposit will be made today.
a) a. How large must the deposit be ?

0
|

1
|

2
|

3
|

4
|

PV = ?

-10,000

-10,000

-10,000

-10,000

With a calculator, enter N = 4, I/YR = 7, PMT = -10000, and FV = 0. Then press PV to get PV = $33,872.11. b. (1)
How much will be in the account immediately after you make the first withdrawal ? After the last withdrawal ?

At this point, we have a 3-year, 7% annuity of $10,000 whose present value is $26,243.16: N = 3, I/YR = 7, PMT = -10000, and FV = 0. Then press PV to get PV = $26,243.16. You can also think of the problem as follows: (Beginning balance)(1+I) PMT = Ending balance $33,872.11 (1.07) $10,000 = $26,243.16.

(2)

Zero after the last withdrawal.

Chapter 5

5-2

Yield to Maturity for Annual Payments

Wilson Wonderss bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 10%. The bonds sell at a price of $850. What is their yield to maturity? With your financial calculator, enter the following: N = 12; PV = -850; PMT = 0.10 1,000 = 100; FV = 1000; I/YR = YTM = ? YTM = 12.48%.

5-3

Current Yield for Annual Payments

Heath Foodss bonds have 7 years remaining to maturity. The bonds have a face value of $1,000 and a yield to maturity of 8%. They pay interest annually and have a 9% coupon rate. What is their current yield? With your financial calculator, enter the following to find the current value of the bonds, so you can then calculate their current yield: N = 7; I/YR = YTM = 8; PMT = 0.09 1,000 = 90; FV = 1000; PV = VB = ? PV = $1,052.06. Current yield = $90/$1,052.06 = 8.55%. Alternatively, VB = $90((1- 1/1.087)/0.08) + $1,000(1/1.087) = $1,052.06. Current yield = $90/$1,052.06 = 8.55%.

5-6

Maturity Risk Premium

The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2year Treasury security yields 6.3%. What is the maturity risk premium for the 2-year security?

r* = 3%; IP = 3%; rT-2 = 6.3%; MRP2 = ? rT-2 = r* + IP + MRP = 6.3% rT-2 = 3% + 3% + MRP = 6.3% MRP = 0.3%.

5-8

Yield to Maturity and Call with Semiannual Payments

Thatcher Corporations bonds will mature in 10 years. The bonds have a face value of $1,000 and an 8% coupon rate, paid semiannually. The price of the bonds is $1,100. The bonds are callable in 5 years at a call price of $1,050. What is their yield to maturity? What is their yield to call?

With your financial calculator, enter the following to find YTM: N = 10 2 = 20; PV = -1100; PMT = 0.08/2 1,000 = 40; FV = 1000; I/YR = YTM = ? YTM = 3.31% 2 = 6.62%. With your financial calculator, enter the following to find YTC: N = 5 2 = 10; PV = -1100; PMT = 0.08/2 1,000 = 40; FV = 1050; I/YR = YTC = ? YTC = 3.24% 2 = 6.49%.

5-12

Bond Yields and Rates of Return

A 10-year, 12% semiannual coupon bond with a par value of $1,000 may be called in 4 years at a call price of $1,060. The bond sells for $1,100. (Assume that the bond has just been issued.) a)
a.

What is the bonds yield to maturity?

Using a financial calculator, input the following: N = 20, PV = -1100, PMT = 60, FV = 1000, and solve for I/YR = 5.1849%. However, this is a periodic rate. The nominal annual rate = 5.1849%(2) = 10.3699% 10.37%. b) b. What is the bonds current yield?

The current yield = $120/$1,100 = 10.91%. c) c. What is the bonds capital gain or loss yield?

YTM = Current Yield + Capital Gains (Loss) Yield 10.37% = 10.91% + Capital Loss Yield -0.54% = Capital Loss Yield. d) d. What is the bonds yield to call?

Using a financial calculator, input the following: N = 8, PV = -1100, PMT = 60, FV = 1060, and solve for I/YR = 5.0748%. However, this is a periodic rate. The nominal annual rate = 5.0748%(2) = 10.1495% 10.15%.

5-13

Yield to Maturity and Current Yield

You just purchased a bond that matures in 5 years. The bond has a face value $1,000 and has an 8% annual coupon. The bond has a current yield of 8.21%. What is the bonds yield to maturity?The problem asks you to solve for the YTM, given the following facts: N = 5, PMT = 80, and FV = 1000. In order to solve for I/YR we need PV. However, you are also given that the current yield is equal to 8.21%. Given this information, we can find PV. Current yield 0.0821 PV = Annual interest/Current price = $80/PV = $80/0.0821 = $974.42.

Now, solve for the YTM with a financial calculator: N = 5, PV = -974.42, PMT = 80, and FV = 1000. Solve for I/YR = YTM = 8.65%.

5-17

Bond Value as Maturity Approaches

An investor has two bonds in his portfolio. Each bond matures in 4 years, has a face value of $1,000, and has a yield to maturity equal to 9.6%. One bond, Bond C, pays an annual coupon of 10%; the other bond, Bond Z, is a zero coupon bond. Assuming that the yield to maturity of each bond remains at 9.6% over the next 4 years, what will be the price of each of the bonds at the following time periods? Fill in the following table:

t 0 1 2 3 4

Price of Bond C $1,012.79 1,010.02 1,006.98 1,003.65 1,000.00

Price of Bond Z $ 693.04 759.57 832.49 912.41 1,000.00

5-18

Determinants of Interest Rates

The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year, and

then 3.5% thereafter. The maturity risk premium is estimated to be 0.0005x (t-1), where t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury security?

r = r* + IP + MRP + DRP + LP. r* = 0.02. IP = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035. MRP = 0.0005(6) = 0.003. DRP = 0. LP = 0. r = 0.02 + 0.035 + 0.003 = 0.058 = 5.8%.