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Unformatted text preview: ation tax shield = (P / 10 – $3,333.33)(.34) The present value of the incremental depreciation tax shield will be: PVDepreciation tax shield = (P / 10)(.34)(PVIFA15%,10) – $3,333.33(.34)(PVIFA15%,10) The new harvester will generate year-end pre-tax cash flow savings of $12,000 per year for 10 years. We can find the aftertax present value of the cash flows savings as: PVSsavings = C1(1 – tC)(PVIFA15%,10) PVSsavings = $12,000(1 – 0.34)(PVIFA15%,10) PVSsavings = $39,748.65 The break-even purchase price of the new harvester is the price, P, which makes the NPV of the machine equal to zero. NPV = –P + Salvage valueOld + PVDepreciation tax shield + PVSavings $0 = –P + $23,213.33 + (P / 10)(.34)(PVIFA15%,10) – $3,333.33(.34)(PVIFA15%,10) + $39,748.65 P – (P / 10)(.34)(PVIFA15%,10) = $62,961.98 – $3,333.33(34)(PVIFA15%,10) P[1 – (1 / 10)(.34)(PVIFA15%,10) = $57,274.05 P = $69,057.97 215 CHAPTER 8 INTEREST RATES AND BOND VALUATION
Answers to Concept Questions 1. 2. 3. No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury securities have substantial interest rate risk. All else the same, the Treasury security will have lower coupons because of its lower default risk, so it will have greater interest rate risk. No. If the bid were higher than the ask, the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price. How many such transactions would you like to do? Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must be higher. Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are used to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond issuers also simply ask potential purchasers what coupon rate would be necessary to attract them. The coupon rate is fixed and simply determines what the bond’s coupon payments will be. The required return is what investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required return are equal only if the bond sells for exactly at par. Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal. Their primary concern is that an investment provides the needed nominal dollar amounts. Pension funds, for example, often must plan for pension payments many years in the future. If those payments are fixed in dollar terms, then it is the nominal return on an investment that is important. Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell; many large investors are prohibited from investing in unrated issues. Treasury bonds have no credit risk since it is backed by the U.S. government, so a rating is not necessary. Junk bonds often are not rated because there would be no point in an issuer paying a rating agency to assign its bonds a low rating (it’s like paying someone to kick you!). The term structure is based on pure discount bonds. The yield curve is based on coupon-bearing issues. 4. 5. 6. 7. 8. 9. 10. Bond ratings have a subjective factor to them. Split ratings reflect a difference of opinion among credit agencies. 11. As a general constitutional principle, the federal government cannot tax the states without their consent if doing so would interfere with state government functions. At one time, this principle was thought to provide for the tax-exempt status of municipal interest payments. However, modern court rulings make it clear that Congress can revoke the municipal exemption, so the only basis now appears to be historical precedent. The fact that the states and the federal government do not tax each other’s securities is referred to as “reciprocal immunity.” 12. Lack of transparency means that a buyer or seller can’t see recent transactions, so it is much harder to determine what the best bid and ask prices are at any point in time. 13. When the bonds are initially issued, the coupon rate is set at auction so that the bonds sell at par value. The wide range coupon of coupon rates shows the interest rate when the bond was issued. Notice that interest rates have evidently declined. Why? 14. Companies charge that bond rating agencies are pressuring them to pay for bond ratings. When a company pays for a rating, it has the opportunity to make its case for a particular rating. With an unsolicited rating, the company has no input. 15. A 100-year bond looks like a share of preferred stock. In particular, it is a loan with a life that almost certainly exceeds the life of the lender, assuming that the lender is an individual. With a junk bond, the credit risk can be so high that the borrower is almost certain to default, meaning that the creditors are very likely to end up as part owners of the business. In both cases, the “equity in disguise” has a significant tax advantage. 16. a. b. The bond price is the present value of the cash flows from a bond. The YTM is the interest rate used in valuing the cash flows from a bond. If the coupon rate is higher than the required return on a bond, the bond w...
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