Question

Apple Inc. has just issued a bond with a 10-year maturity, 4% coupon rate, and $1,000 face value. The bond carries a credit rating of AA by the Standard & Poor’s. Investors’ required return on bonds of similar risk is 5%. Please answer the following questions:

1. Please calculate the price of the bond, assuming annual coupon payments.

2. Please calculate the price of the bond, assuming semi-annual coupon payments.

3．Suppose Standard and Poor’s suddenly upgrades the firm’s credit rating from AA to AAA, what is the immediate impact on the price of the bond? Please explain.

4. Suppose the Federal Reserve suddenly cuts interest rates. What is the immediate impact on the price of the bond? Please explain.

Answer 1

1) Calculation of Price of bond assuming annual coupon payments:

Interest = 1000*4% = 40

Particulars	Period	Cash flow (1)	Discount rate @ 5% (2)	Discounted cash flows (3) (1*2)
Interest	1-10	40	7.7217	308.868
Maturity value	10	1000	0.6139	613.9
			Price of bond	922.768

2) Calculation of price of the bond assuming semi annual coupon payments:

Interest = 1000*4%*6/12 = 20

Since the interest paid semiannually that means interest is payable twice in a year, hence no.of coupon payments = 10*2 = 20

Particulars	periods	Cash flows (1)	Discount rate @5% (2)	Discounted CF (3) (1*2)
Interest	1-20	20	12.4622	249.244
Maturity value	20	1000	0.3769	376.9
			Price of bond	626.144

3) Credit rating upgrades to AA to AAA, impact on price of the bond:

A change in credit rating of a bond changes the yield of the bond offers. Generally if the company has good credit rating then the creditworthiness of the company will automatically increases and confidence of stakeholders will increase.In the present situation company rating has changes from AA to AAA, that means it got good credit rating so it gains the interest of stakeholders and hence the price of the bond increases automatically.

4) If federal bank cuts interest rate, effect on price of the bond:

If interest rates are lower then the market value of the bond increases. In the given situation if federal bank cuts the interest rates then the price of the bond increases because if the interest rate is less then the investors will get better rate of return than elsewhere and if the interest rate is higher the bond prices decreases because the investors can get the better rate of return elsewhere.