Part 4 Ch 05


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CHAPTER 5 INTEGRATIVE PROBLEM SECTION I. BOND VALUATION ANSWER : Some of the key features of a bond include the following: (1) Par or face value . We generally assume a $1,000 par value, but par can be anything, and often $5,000 or more is used. (2) Coupon rate . The dollar coupon is the “rent” on the money borrowed, which is generally the par value of the bond. The coupon rate is the annual interest payment divided by the par value, and it is generally set at the value of k on the day the bond is issued. To illustrate, the required rate of return on one of Tampa Electric’s bonds was 8 percent when they were issued, so the coupon rate was set at 8 percent. If the company were to float a new issue today, the coupon rate would be set at the going rate today (2004), which would be about 5 or 6 percent. (3) Maturity. This is the number of years until the bond matures and the issuer must repay the loan (return the par value). (4) call provision. Most bonds (except U.S. Treasury bonds) can be called and paid off ahead of schedule after some specified “call protection period.” Generally, the call price is above the par value by some “call premium.” We will see that companies tend to call bonds if interest rates decline after the bonds were issued, so they can refund the bonds with lower interest bonds. This is just like homeowners refinancing their mortgages if mortgage interest rates decline. (5) Issue date . The date the bond is originally issued. (6) D efault risk is inherent in all bonds except Treasury bonds. The question here is: Will the issuer have the cash to make the promised payments? Bonds are rated from AAA to D, and the lower the rating, the riskier the bond, the higher its default risk premium, and, consequently, the higher its required rate of return, k. (7) Special features , such as convertibility and zero coupons, will be discussed later. 76 5-23 ROBERT CAMPBELL AND CAROL MORRIS ARE SENIOR VICE PRESIDENTS OF THE MUTUAL OF CHICAGO INSURANCE COMPANY. THEY ARE CODIRECTORS OF THE COMPANY’S PENSION FUND MANAGEMENT DIVISION, WITH CAMPBELL HAVING RESPONSIBILITY FOR FIXED INCOME SECURITIES (PRIMARILY BONDS) AND MORRIS BEING RESPONSIBLE FOR EQUITY INVESTMENTS. A MAJOR NEW CLIENT, THE CALIFORNIA LEAGUE OF CITIES, HAS REQUESTED THAT MUTUAL OF CHICAGO PRESENT AN INVESTMENT SEMINAR TO THE MAYORS OF THE REPRESENTED CITIES, AND CAMPBELL AND MORRIS, WHO WILL MAKE THE ACTUAL PRESENTATION, HAVE ASKED YOU TO HELP THEM BY ANSWERING THE FOLLOWING QUESTIONS: A. WHAT ARE THE KEY FEATURES OF A BOND?
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B. HOW IS THE VALUE OF ANY ASSET WHOSE VALUE IS BASED ON EXPECTED FUTURE CASH FLOWS DETERMINED? ANSWER : 0 1 2 3 n-1 n 1 ^ CF 2 ^ CF 3 ^ CF 1 n ^ CF - n ^ CF PV of 1 ^ CF PV of 2 ^ CF PV of 3 ^ CF PV of 1 n ^ CF - PV of n ^ CF Asset Value The value of an asset is merely the present value of its expected future cash flows: .
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This note was uploaded on 03/31/2012 for the course BUS 200 taught by Professor Bens during the Spring '12 term at FIU.

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