The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual
ID: 2706820 • Letter: T
Question
The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual interest plus $1,000 maturity. Bond 1 has a maturity of 15 years, and Bond S has a maturity of 1 year.
A. What will be the value of each of these bonds when the going rate of interest is (1) 5% (2) 8% (3) 12%? Assume that there is only one more interest payment to be made on Bond S
B. Why does longer-term (15 year) bond fluctuate more when interest rate change than does the shorter-term bond (1 year)?
The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual interest plus $1,000 maturity. Bond 1 has a maturity of 15 years, and Bond S has a maturity of 1 year. What will be the value of each of these bonds when the going rate of interest is (1) 5% (2) 8% (3) 12%? Assume that there is only one more interest payment to be made on Bond S Why does longer-term (15 year) bond fluctuate more when interest rate change than does the shorter-term bond (1 year)?Explanation / Answer
(1) Bond L = $1,519 & Bond S = $1,047.6
Both bond trade at a premium because the pay a lot more interest than the market does (i.e. 100/1000 = 10% > 5%)
(2) Bond L = $1,171.2 & Bond S = $1,018.5
Same as (1) but now the premium is less because the market interest (8%) is closer to the bond interest(10%)
(3) Bond L = $863.8 & Bond S = $982.14
Now the bonds trade at a discount because the market rate (12%) is higher than the bond rate (10%).
b.
in fixed income terms, because the duration of bond L is greater than the duration of bond S. In simpler terms, bond L has a greater maturity (15 years vs. 1 year) therefore the more time the bond is outstanding the more copuon payments it will make and the more this coupon deffer from the market rates the more price impact they will have. A bit confusuing, lets try an example, lets assume you have a AAA bond (AAA is the credit rating of the bond, it means it is very secure) that pays you a copon rate of 10% a year and you wanted to sell it the market at this time (right now) you would sell it at premium because none of the AAA bonds out there pay that kind of interest (more like 6% to 7%). Basically, when you buy a bond you buy a stream of cash flows that you are going to receive into the future, if this cash flows are secure, the more deviation they have from market prevailing rates and the more time until maturity they have, the more price impact they will have on the bond price.
2.
$5 / $60 = 8.33% Preferred Stock's required rate of return
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