Question

Below are yields of risk-free zero-coupon $1,000-par-value bonds of various maturities.

Maturity (years)	1	2	3	4	5
YTM	3.25%	3.50%	3.9%	4.25%

1. Fill in the blank if market price of the five-year zero-coupon bond is 809.79.
2. Construct yield curve using values from the table.
3. Suppose you would like to finance a project with equity. The project is expected to deliver cash flows during the next 3 years. Which of the risk-free rates from the table above you would use to estimate projects’ cost of capital? Explain your choice.

Answer 1

Part A:

Part A:

YTM :

YTM is the rate at which PV of Cash inflows are equal to Bond price when the bond is held till maturity.
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures.
Yield to maturity is considered a long-term bond yield but is expressed as an annual rate

Particulars	Amount
Maturity price	$   1,000.00
Current Price	$      809.79
Maturity period	5

YTM = [ Maturity Value / Current Price ] ^ ( 1 / n ) - 1
= [ $ 1000 / $ 809.79 ] ^ ( 1 / 5) - 1
= [ 1.2349 ] ^ ( 1 / 5) - 1
= 1.0431 - 1
= 0.0431
I.e 4.31 %

Part B:

Part C:

If the CFs are there for 3 Years, use YTM of Three year bond I.e 3.90%