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Unformatted text preview: Chapter 7: Bonds and Their Valuation Learning Objectives 137 Chapter 7 Bonds and Their Valuation Learning Objectives After reading this chapter, students should be able to: Identify the different features of corporate and government bonds. Discuss how bond prices are determined in the market, what the relationship is between interest rates and bond prices, and how a bonds price changes over time as it approaches maturity. Calculate a bonds yield to maturity and its yield to call if it is callable and determine the true yield. Explain the different types of risk that bond investors and issuers face and the way a bonds terms and collateral can be changed to affect its interest rate. 138 Integrated Case Chapter 7: Bonds and Their Valuation Answers to End-of-Chapter Questions 7-1 From the corporations viewpoint, one important factor in establishing a sinking fund is that its own bonds generally have a higher yield than do government bonds; hence, the company saves more interest by retiring its own bonds than it could earn by buying government bonds. This factor causes firms to favor the second procedure. Investors also would prefer the annual retirement procedure if they thought that interest rates were more likely to rise than to fall, but they would prefer the government bond purchase program if they thought rates were likely to fall. In addition, bondholders recognize that, under the government bond purchase scheme, each bondholder would be entitled to a given amount of cash from the liquidation of the sinking fund if the firm should go into default, whereas under the annual retirement plan, some of the holders would receive a cash benefit while others would benefit only indirectly from the fact that there would be fewer bonds outstanding. On balance, investors seem to have little reason for choosing one method over the other, while the annual retirement method is clearly more beneficial to the firm. The consequence has been a pronounced trend toward annual retirement and away from the accumulation scheme. 7-2 Yes, the statement is true. 7-3 False. Short-term bond prices are less sensitive than long-term bond prices to interest rate changes because funds invested in short-term bonds can be reinvested at the new interest rate sooner than funds tied up in long-term bonds. For example, consider two bonds, both with a 10% annual coupon and a $1,000 par value. The only difference between them is their maturity. One bond is a 1-year bond, while the other is a 20-year bond. Consider the values of each at 5%, 10%, 15%, and 20% interest rates. 1-year 5% $1,047.62 $1,623.11 20-year 10% 1,000.00 1,000.00 15% 956.52 687.03 20% 916.67 513.04 As you can see, the price of the 20-year bond is much more volatile than the price of the 1-year bond....
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- Spring '10