Sam Strother and Shawna Tibbs are vice presidents of
Mutual of Seattle Insurance Company and co-directors of the
company’s pension fund management division. An
important new client, the North-Western Municipal Alliance, has
requested that Mutual of Seattle present an investment seminar to
the mayors of the represented cities, and
Strother and Tibbs, who will make the actual presentation, have
asked you to help them by answering the following
a. What are the key features of a bond?
b. What are call provisions and sinking fund provisions? Do these
provisions make bonds more or less risky?
c. How does one determine the value of any asset whose value is
based on expected future cash flows?
d. How is the value of a bond determined? What is the value of a
10-year, $1,000 par value bond with a 10% annual coupon if its
required rate of return is 10%?
(1) What would be the value of the bond described in
Part d if, just after it had been issued, the expected inflation
rate rose by 3 percentage points, causing investors to require a
13% return? Would we now have a discount or a premium
(2) What would happen to the bond’s value if inflation fell and rd
declined to 7%? Would we now have a premium or a discount
(3) What would happen to the value of the 10-year bond over time if
the required rate of return remained at 13%? If it remained at 7%?
(Hint: With a financial calculator, enter PMT, I/YR, FV, and N, and
then change N to see what happens to the PV as the bond approaches
(1) What is the yield to maturity on a 10-year, 9%
annual coupon, $1,000 par value bond that sells for $887.00? That
sells for $1,134.20? What does the fact that a bond sells at a
discount or at a premium tell you about the relationship between rd
and the bond’s coupon rate?
(2) What are the total return, the current yield, and the capital
gains yield for the discount bond? (Assume the bond is held to
maturity and the company does not default on the
g. How does the equation for valuing a bond change if semiannual
payments are made? Find the value of a 10-year, semiannual payment,
10% coupon bond if the nominal rd 13%.
h. Suppose a 10-year, 10% semiannual coupon bond with a par value
of $1,000 is currently selling for $1,135.90, producing a nominal
yield to maturity of 8%. However, the bond can be called after 5
years for a price of $1,050.
(1) What is the bond’s nominal yield to call
(2) If you bought this bond, do you think you would be more likely
to earn the YTM
or the YTC? Why?
i. Write a general expression for the yield on any debt security rd
and define these terms: real risk-free rate of interest (r ),
inflation premium (IP), default risk premium (DRP), liquidity
premium (LP), and maturity risk premium (MRP).
j. Define the real risk-free rate (r ). What security can be used
as an estimate of r ? What is the nominal risk-free rate rRF ? What
securities can be used as estimates of rRF?
k. Describe a way to estimate the inflation premium (IP) for a
l. What is a bond spread and how is it related to the default risk
premium? How are bond ratings related to default risk? What factors
affect a company’s bond rating?
m. What is interest rate (or price) risk? Which bond has more
interest rate risk: an annual payment 1-year bond or a 10-year
n. What is reinvestment rate risk? Which has more reinvestment rate
risk: a 1-year bond or a 10-year bond?
o. How are interest rate risk and reinvestment rate risk related to
the maturity risk premium?
p. What is the term structure of interest rates? What is a yield
q. Briefly describe bankruptcy law. If a firm were to default on
its bonds, would the company be liquidated immediately? Would the
bondholders be assured of receiving all of their promised
Thress Industries just paid a dividend of $1.50 a share
(i.e., D0 $1 50). The dividend is expected to grow 5% a year for
the next 3 years and then 10% a year thereafter. What is the
expected dividend per share for each of the next 5
You buy a share of The Ludwig Corporation stock for
$21.40. You expect it to pay dividends of $1.07, $1.1449, and
$1.2250 in Years 1, 2, and 3, respectively, and you expect to sell
it at a price of $26.22 at the end of 3 years.
a. Calculate the growth rate in dividends.
b. Calculate the expected dividend yield.
c. Assuming that the calculated growth rate is expected to
continue, you can add the dividend yield to the expected growth
rate to obtain the expected total rate of return. What is this
stock’s expected total rate of return (assume the market is in
equilibrium with the required return equal to the expected