price could sun devil savings sell B u s i n e s s F i n a n c e

1. An inflationindexed Treasury bond has a par value of $1,000

and a coupon rate of 6 percent. An investor

purchases this bond and holds it for one year.

During the year, the consumer price index increases

by 1 percent every six months. What are the total

interest payments the investor will receive during

the year?

2. Assume that the

U.S. economy experienced deflation during the year and

that the consumer price index decreased by 1 percent in

the first six months of the year and by 2 percent during the

second six months of the year. If an investor had purchased inflation-indexed Treasury bonds with a par value

of $10,000 and a coupon rate of 5 percent, how much

would she have received in interest during the year?

3. Assume the following information

for an existing bond that provides annual coupon

payments:

Par value ¼ $1,000

Coupon rate ¼ 11%

Maturity ¼ 4 years

Required rate of return by investors ¼ 11%

a. What is the present value of the bond?

b. If the required rate of return by investors was

14 percent instead of 11 percent, what would be the

present value of the bond?

c. If the required rate of return by investors was

9 percent, what would be the present value of the

bond?

4. Valuing a Zero-Coupon Bond Assume the following information for existing zero-coupon bonds:

Par value ¼ $100,000

Maturity ¼ 3 years

Required rate of return by investors ¼ 12%

How much should investors be willing to pay for

these bonds?

5. Assume that you

require a 14 percent return on a zero-coupon bond

with a par value of $ 1,000 and six years to maturity.

What is the price you should be willing to pay for this

bond?

6. Cardinal Company, a U.S.-based insurance company, considers purchasing bonds denominated in Canadian dollars, with a maturity of six years, a

par value of C$50 million, and a coupon rate of 12 percent. Cardinal can purchase the bonds at par. The current exchange rate of the Canadian dollar is $0.80.

Cardinal expects that the required return by Canadian

investors on these bonds four years from now will be

9 percent. If Cardinal purchases the bonds, it will sell

them in the Canadian secondary market four years from

now. It forecasts the exchange rates as follows:

YEAR EXCHANGE

RATE OF C$ YEAR EXCHANGE

RATE OF C$

1 $0.80 4 $0.72

2 0.77 5 0.68

3 0.74 6 0.66

a. Refer to earlier examples in this chapter to determine the expected U.S. dollar cash flows to Cardinal

over the next four years.

b. Does Cardinal expect to be favorably or adversely

affected by the interest rate risk? Explain.

c. Does Cardinal expect to be favorably or adversely

affected by exchange rate risk? Explain.

7. (Use the chapter appendix to answer this problem.) Bulldog Bank has just

purchased bonds for $106 million that have a par value

of $100 million, three years remaining to maturity, and

an annual coupon rate of 14 percent. It expects the

required rate of return on these bonds to be 12 percent

one year from now.

a. At what price could Bulldog Bank sell these bonds

one year from now?

b. What is the expected annualized yield on the bonds

over the next year, assuming they are to be sold in one

year?

8. (Use the chapter appendix

to answer this problem.) Sun Devil Savings has just

purchased bonds for $38 million that have a par value of

$40 million, five years remaining to maturity, and a

coupon rate of 12 percent. It expects the required rate of

return on these bonds to be 10 percent two years from now.

a. At what price could Sun Devil Savings sell these

bonds two years from now?

b. What is the expected annualized yield on the bonds

over the next two years, assuming they are to be sold in

two years?

c. If the anticipated required rate of return of 10 percent in two years is overestimated, how would the

actual selling price differ from the forecasted price?

How would the actual annualized yield over the next

two years differ from the forecasted yield?

9. (Use the chapter appendix

to answer this problem.) Spartan Insurance Company

plans to purchase bonds today that have four years

remaining to maturity, a par value of $60 million, and a

coupon rate of 10 percent. Spartan expects that in three

years, the required rate of return on these bonds by

investors in the market will be 9 percent. It plans to sell

the bonds at that time. What is the expected price it will

sell the bonds for in three years?

10. (Use the chapter appendix to answer

this problem.) Hankla Company plans to purchase

either (1) zero-coupon bonds that have 10 years to

maturity, a par value of $100 million, and a purchase

price of $40 million; or (2) bonds with similar default

risk that have five years to maturity, a 9 percent coupon rate, a par value of $40 million, and a purchase

price of $40 million.

Hankla can invest $40 million for five years.

Assume that the market’s required return in five years

is forecasted to be 11 percent. Which alternative would

offer Hankla a higher expected return (or yield) over

the five-year investment horizon?