Question

Lynn Parsons is considering investing in either of two outstanding bonds. The bonds both have ​$1000 par values and 14​% coupon interest rates and pay annual interest. Bond A has exactly 7 years to​ maturity, and bond B has 17 years to maturity.  

a.Calculate the present value of bond A if the required rate of return​ is: (1) 11​%, ​(2) 14​%, and​ (3) 17​%.

b.Calculate the present value of bond B if the required rate of return​ is: (1) 11​%, ​(2) 14​%, and​ (3) 17​%.

c. From your findings in parts a and b​, discuss the relationship between time to maturity and changing required returns.

d.If Lynn wanted to minimize interest rate​ risk, which bond should she​ purchase? ​ Why?

Answer 1

a.Present Value of bond is equal to the present value of all coupon payments and principal amount

11%, PV = 140*PVAF(11%, 7 years) + 1,000*PVF(11%, 7 years)

= 140*4.712 + 1,000*0.482

= $1,141.68

14%, 140*4.288 + 1,000*0.400

= $1,000.32

17%, 140*3.922 + 1,000*0.333

= $882.08

b.11%, 140*7.549 +1,000*0.170

= $1,226.86

14%, 140*6.373 + 1,000*0.108

= $1,000.22

17%, 140*5.475 + 1,000*0.069

= $835.5

c.Value of bond reduces with increase in required rate of return. Higher the time, higher is the impact.

d. To minimize interest rate risk, Bond A should be purchased since it has lower time to maturity