# If market rates increase over the time period

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Unformatted text preview: ws discounted using a discount rate of 6% semiannually must be greater than or equal to \$891.60. If the present value is less, the bonds would not provide an annual rate of return of at least 12%. The present value of the bonds using a discount rate per six­month period of 6% is: Present value (i = 6%, n = 16) PV of maturity receipt \$ PV of interest receipts (\$1,000 .39365) 393.65 [(\$1,000 404.24 \$ 797.89 10.10590) Total present value 4%) Since the present value of the future cash flows is less than \$891.60, the bonds are providing an annual rate of return of less than 12%. Thus, the bonds do not provide the required rate of return, and they should not be considered for investment purposes. b. The annual effective interest rate that would make an investor indifferent to purchasing the bonds at 89.16 would be 10%, which implies a six­month rate of 5%. As proof: Present value (i = 5%, n = 16) PV of maturity receipt \$ PV of interest receipts 10.83777) Total present value (i.e., proceeds) (\$1,000 .45811) 458.11 [(\$1,000 433.51 \$ 891.62 4%) At an annual effective rate of 10%, an investor would be indifferent to purchasing the bonds. E11–27 a. b. Bonneville issued the debt at a fixed rate, meaning that its outlay for interest will not change even if market interest rates change. A drop in market rates would not lower the interest paid by Bonneville; therefore, such a drop would increase the liability on the books of the company. In effect, the company would be paying above­market rates for its debt due to the fixed nature of the contract. Bonneville could manage the risk of fluctuating interest rates (and debt values) by entering into a hedging agreement known as an interest rate swap. Under a swap arrangement, Bonneville would agree with a counter party, most likely a large commercial bank, to receive periodic payments at a fixed rate of interest while also agreeing to pay out periodic payments that are tied to a floating rate of interest (Treasury Bills, for example). If market rates increase over the time period, Bonneville will make larger periodic payments under the swap agreement, while a...
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