e1f09key - AP/ADMS 4540 Financial Management Fall 2009 Exam...

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1 AP/ADMS 4540 Financial Management Fall 2009 Exam 1 Answer Key Instructor: Dr. William Lim Question 1 (15 marks) Calculate the duration and volatility of a 5-year, $1,000 face value, 14 percent coupon bond yielding 15 percent with coupons paid annually. (12 marks) Using its duration and volatility, calculate what happens to the price of the bond when the yield to maturity falls to 14 percent. (3 marks) Note: Show all working steps, including calculations of PV, RV and WV, clearly for full credit. Time Payment PV RV WV 1 140 121.74 0.12596 0.12596 2 140 105.86 0.10953 0.21906 3 140 92.05 0.09524 0.28572 4 140 80.04 0.08282 0.33128 5 1,140 566.78 0.58645 2.93225 Bond Price = 966.47 1.00000 3.89427=Duration Duration = D = 3.89427 years Volatility = v = -D/(1+r) = -3.89427/1.15 = -3.416% [12] When yield falls by one percent, price rises by 3.416% or $33.01 New price = $966.47+$33.01 = $999.48. [3] Question 2 (20 marks) With Canadian interest rates at historical lows, McGraw-Hill Ryerson (MHR) is considering whether to refund an old issue of $30 million, 12 percent coupon (paid yearly) 20-year bonds that were sold 5 years ago. A new issue of $30 million, 15-year bonds can be sold with a coupon rate of 9 percent (paid yearly). A call premium of 10 percent will be required to retire the old bonds and floatation costs of $2 million will apply to the new issue. The marginal tax rate applicable is 50 percent and MHR expects that there will be a one month overlap during which any funds can be invested in t-bills yielding 8 percent. Should MHR refund? Note: Show all four working steps clearly. Step 1: Find appropriate after tax discount rate r. r = (1-0.5) * 9% = 4.5% [4] Step 2: Find costs of refunding. Call premium costs = 10% * 30,000,000 = 3,000,000 [2] Floatation Costs = 2,000,000 Less PV of future tax savings = (2000000/5)*0.5*PVIFA(5,4.5%) = 400000*0.5*4.39 = 878,000 Net Floatation Costs = 2,000,000 - 878,000 = 1,122,000 [4] After tax additional interest paid on old bonds = (1-0.5)*12%*1/12*30000000 = 150,000 After tax additional interest received on t-bills = (1-0.5)*8%*1/12*30000000 = 100,000 Net Additional Interest = 150,000 - 100,000 = 50,000 [3] Total costs of refunding = Call premium costs + Net Floatation Costs + Net Additional Interest = 1,800,000 + 561,000 + 50,000 = 4,172,000 [1] Step 3: Find benefits of refunding
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e1f09key - AP/ADMS 4540 Financial Management Fall 2009 Exam...

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