Fin550Midterm_2014_KEY.pdf

We need to determine what the risk of the metro bonds

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We need to determine what the risk of the Metro Bonds will be. We are told that the bonds will have 10 years to maturity (issued in 2006 and mature in 2016), and they are rated AA by S&P. If you recall, there are several ways to estimate R d . The takeaway slide from that class is reproduced below: 1. USING THE COMPANY’S OWN BONDS NO COMPARABLE BOND The first method is to find the existing YTM on the firm’s own bonds of similar time to maturity. There are no Metro Power bonds that are close to a 10 year maturity. The closest that we have is a Metro Power Bond that matures on April 1 st , 2012 thus it has 5½ years remaining. Recall that bond pricing is nonlinear so using a 5 ½ year bond to estimate a 10 year bond is probably a poor choice. 5.23%

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9 2. USING BONDS OF SIMILAR RISK (DOMINION POWER) 5.23% A second option is to use similar bonds. Those in the same industry, with the same bond rating and time to maturity. There are 2 electric utility bonds that have 10 years to maturity: Dominion Power and PEPCO. However, the PEPCO bond is rated BBB+ and the Dominion Power bond is rated AA. Since the Metro bond is rated AA, the Dominion Power bond is a better choice since it is “more similar” in terms of risk. We only need to calculate the YTM on the Dominion Power bond. Recall that bond pricing is an application of time value of money. The current bond price is the present value of the coupon payments plus the present value of the face value. Because the series of coupon payments is a series of constant payments, we can use the present value annuity formula to calculate the present value of the coupon payments.

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