week 7

·  Assume Mr. Davis can buy either a $10,000 corporate bond yielding 10% or a municipal bond yielding 7%. Assume risk is constant. Assume also that his Federal tax rate will be 28% and his State tax rate 7% and that the municipal bond is exempt from both types of income taxes.

Which should he buy, if the yield and tax consequences are the only variables? 

·  A bond has the following terms:

(When asked for a % yield, round yields to nearest tenth of a percent, such as 10.1 %.)

1. What is the bond’s price if comparable debt yields 12%?
2. What would be the price if comparable debt yields 12% and the bond matures after 5 years?
3. What are the current yields and yields to maturity if a. and b.?
4. What would be the bond’s price in a. if interest rates declined to 8%? What if the bond matures after 5 years?
5. What are the current yields and yields to maturity in d.?
6. What two generalizations may be drawn from the above price changes?

·  You purchase a high-yield, junk bond for $1,000 that pays $140 annually. After buying the bond, yields decline and you are able to reinvest the interest at only 9 percent. You reinvest all the interest payments.

How much will you have when the bond is retired after 12 years? What was the annual return you earned on this investment?

·  Determine the current market prices of the following $1,000 bonds if the comparable rate is 10% and answer the questions.

• XY 5 ¼ percent, with interest paid annually for 20 years.
• AB 14 percent, with interest paid annually for 20 years.

1. Which bond has a current yield that exceeds the yield to maturity?
2. Which bond may you expect to be called? Why?
3. If CD, Inc. has a bond with a 5 ¼ percent coupon and a maturity of 20 years but which was lower rated, what would be its price relative to the XY, Inc. bond? Explain