Case Study

2170 words 9 pages
1. To begin, assume that it is now January 1, 1993, and that each bond in Table 1 matures on December 31 of the year listed. Further, assumes that each bond has $1,000 par value, each had a 30-year maturity when it was issued, and the bonds currently have a 10 percent required nominal rate or return.

a. Why do the bonds’ coupon rates vary so widely?

It is because TECO sells bonds at par and sets the coupon rates at the market rate of interest when the bonds are issued, interest rates have risen over the last 25 years, and that explains the rising pattern of coupon rates.

b. What would be the value of each bond if they had annual coupon payments?

The value of a bond is found as the present value of interest payments plus
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EAR = (1.05090)² - 1.0 = 10.439% b.
Premium 25-year bond:
$126.25
$1,220.00 Current yield = = 10.35%

Discount 25-year bond:
$73.75
$747.48

Current yield = = 10.35%

c.
On January 1, 1989, the bonds will have only 24 years to maturity.

Premium bond:
5.09%,48
5.09%,48
V=$63.125(PVIFA ) = $1,000 (PVIF ) = $1,218.02
$1,218.02 - $1,220.00
$1,220.00

Capital gains yield = = -0.16%

Discount bond:

5.09%,48
5.09%,48
V=$36.875(PVIFA ) = $1,000 (PVIF ) = $749.88
$749.88 - $747.48
$747.48

Capital gains yield = = .32%

d. Each bond price would move towards its par value, $1,000. Thus, the premium bond’s price would fall overtime while the discount bond’s price would rise.

e. The expected total rate of return is merely the sum of the current and capital gains yields. Premium bond: total return = 10.35% = (-.16%) 10.19% Discount bond: Total return = 9.87% = 0.32% 10.19%

f. An investor paying taxes, regardless of the rate, would prefer the discount bond. On this bond, an investor would have to pay taxes on the $73.75 interest payment in each year, but taxes on the $1,000.00 - $747.48 = $252.52 capital gain could be deferred until

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