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The Garraty Co. has two bond issues outstanding. Both bonds pay $100 annual interest plus $1000 at maturity. Bond L has a maturity of 15 years, and Bond S has a maturity of 1 year.

The current price of the bond equals the present value of all future cash flows. Those cash flows are of 2 kinds: 1) Coupon Payments, and 2) Face Value paid at maturity

Bond L:

Face Value = $1,000, Coupon Payment = $100, maturity = 15

Bond S:

Face Value = $1,000, Coupon Payment = $100, maturity = 1

a. What will be the value of each of these bonds when the going rate of interest is 1. 5%, 8% and 12%. Assume that there is only one more interest payment to be made on bond S.

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1) Interest Rate = 5%

Bond L:

[pic]

= ($100 x 10.3797) + ($1,000 x 0.481)

= $1,037.97 + $481.017

= $1,518.98

Bond S:

[pic]

= ($100 x 0.952381) + ($1,000 x 0.952381)

= $95.2381 + $952.381

= $1,047.62

As you can see, the bond sells at a premium (Above Face Value) since the coupon rate is higher than the market rate. The coupon rate is 10%, while the market rate is 5%.

|1) 5% Interest: | | | | |

|Bond L: |  | |Bond S: |  |

|Settlement Date |1/1/00 | |Settlement Date |1/1/00 |

|Maturity Date |1/1/15 | |Maturity Date |1/1/01 |

|Annual Coupon Rate |0.1 | |Annual Coupon Rate |0.1 |

|Yield to Maturity |0.05 | |Yield to Maturity |0.05 |

|Face Value (% of Par) |100 | |Face Value (% of Par) |100 |

|Coupons per Year |1 | |Coupons per Year |1 |

|Bond Price (% of par) |151.8983 | |Bond Price (% of par) |104.7619048 |

|Bond Price |$1,518.98 | |Bond Price |$1,047.62 |

|2) 8% Interest: | | | | |

|Bond L: |  | |Bond S: |  |

|Settlement Date |1/1/00 | |Settlement Date |1/1/00 |

|Maturity Date |1/1/15 | |Maturity Date |1/1/01 |

|Annual Coupon Rate |0.1 | |Annual Coupon Rate |0.1 |

|Yield to Maturity |0.08 | |Yield to Maturity |0.08 |

|Face Value (% of Par) |100 | |Face Value (% of Par) |100 |

|Coupons per Year |1 | |Coupons per Year |1 |

|Bond Price (% of par) |117.119 | |Bond Price (% of par) |101.8518519 |

|Bond Price |$1,171.19 | |Bond Price |$1,018.52 |

|3) 12% Interest: | | | | |

|Bond L: |  | |Bond S: |  |

|Settlement Date |1/1/00 | |Settlement Date |1/1/00 |

|Maturity Date |1/1/15 | |Maturity Date |1/1/01 |

|Annual Coupon Rate |0.1 | |Annual Coupon Rate |0.1 |

|Yield to Maturity |0.12 | |Yield to Maturity |0.12 |

|Face Value (% of Par) |100 | |Face Value (% of Par) |100 |

|Coupons per Year |1 | |Coupons per Year |1 |

|Bond Price (% of par) |86.37827 | |Bond Price (% of par) |98.21428571 |

|Bond Price |$863.78 | |Bond Price |$982.14 |

b. Why does the longer-term (15-year) bond fluctuate more when interest rates change than does the shorter-term bond (1year).

The risk that arises for bond owners from fluctuating interest rates is called Interest Rate Risk. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes.

The reason that longer-term bonds have greater interest rate sensitivity is that a large portion of the bond’s value comes from the $1,000 face amount. The present value of this amount is not greatly affected by a small change in interest rates if the amount to be received in one year. Even a small change in interest rates, however, once it is compounded for 15 years, can have a significant effect on the present value.

8-4. Fee Founders has preferred stock outstanding that pays a dividend of $5 at the end of each year.The preferred stock sells for $60 a share. What is the preferred stock's required rate of return?

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= [pic]

= 0.08333 ( 8.33%

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