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Intermediate

(continued)

Challenge

(Questions 26-29)

PART THREE Valuation of Future Cash Flows c. What is the relationship between the current yield and YTM for premium bonds? For discount bonds? For bonds selling at par value?

23. Interest on Zeroes HSD Corporation needs to raise funds to finance a plant expansion, and it has decided to issue 20-year zero coupon bonds to raise the money. The required return on the bonds will be 9 percent.

a. What will these bonds sell for at issuance?

b. Using the IRS amortization rule, what interest deduction can HSD Corporation take on these bonds in the first year? In the last year?

c. Repeat part (b) using the straight-line method for the interest deduction.

d. Based on your answers in (b) and (c), which interest deduction method would HSD Corporation prefer? Why?

24. Zero Coupon Bonds Suppose your company needs to raise $10 million and you want to issue 30-year bonds for this purpose. Assume the required return on your bond issue will be 9 percent, and you're evaluating two issue alternatives: a 9 percent annual coupon bond and a zero coupon bond. Your company's tax rate is 35 percent.

a. How many of the coupon bonds would you need to issue to raise the $10 million? How many of the zeroes would you need to issue?

b. In 30 years, what will your company's repayment be if you issue the coupon bonds? What if you issue the zeroes?

c. Based on your answers in (a) and (b), why would you ever want to issue the zeroes? To answer, calculate the firm's aftertax cash outflows for the first year under the two different scenarios. Assume the IRS amortization rules apply for the zero coupon bonds.

25. Finding the Maturity You've just found a 10 percent coupon bond on the market that sells for par value. What is the maturity on this bond?

26. Components of Bond Returns Bond P is a premium bond with a 10 percent coupon. Bond D is a 6 percent coupon bond currently selling at a discount. Both bonds make annual payments, have a YTM of 8 percent, and have eight years to maturity. What is the current yield for Bond P? For Bond D? If interest rates remain unchanged, what is the expected capital gains yield over the next year for Bond P? For Bond D? Explain your answers and the interrelationship among the various types of yields.

27. Holding Period Yield The YTM on a bond is the interest rate you earn on your investment if interest rates don't change. If you actually sell the bond before it matures, your realized return is known as the holding period yield (HPY).

a. Suppose that today you buy a 9 percent coupon bond making annual payments for $1,150. The bond has 10 years to maturity. What rate of return do you expect to earn on your investment?

b. Two years from now, the YTM on your bond has declined by 1 percent, and you decide to sell. What price will your bond sell for? What is the HPY on your investment? Compare this yield to the YTM when you first bought the bond. Why are they different?

28. Valuing Bonds The Moulon Rouge Corporation has two different bonds currently outstanding. Bond M has a face value of $20,000 and matures in 20 years. The bond makes no payments for the first six years, then pays $1,000 every six months over the subsequent eight years, and finally pays $1,750 every six

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

7. Interest Rates and Bond Valuation

© The McGraw-Hill Companies, 2002

CHAPTER 7 Interest Rates and Bond Valuation

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Responses

  • abel
    How many zeros coupon bonds do you need to issue?
    8 years ago

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