assume Liam wants to earn a return of 10.50% and is offered the opportunity to p

Question

assume Liam wants to earn a return of 10.50% and is offered the opportunity to purchase a $1,000 par value bond that pays a 9.00% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond’s intrinsic value:

Complete the following table by identifying the appropriate corresponding variables used in the equation.

Unknown

Variable Name

Variable Value

Bond’s semiannual coupon payment

Bondholder’s required return

Bond’s annual coupon payment

$45.00

$72.00

$144.00

$180.00

Bond’s market price

Bond’s par value

Bond’s annual coupon payment

5.25%

10.50%

15.75%

21.00%

Points:

Based on this equation and the data, it is selector 1

unreasonable

reasonable

to expect that Liam’s potential bond investment will exhibit an intrinsic value greater than $1,000.

Points:

Close Explanation

Explanation:

Now, consider the situation in which Liam wants to earn a return of 5%, but the bond being considered for purchase offers a coupon rate of 7%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of selector 1

$950

$422

$1,899

$1,055

is selector 2

equal to

greater than

less than

its par value, so that the bond is trading at selector 3

a discount

a premium

par

.

Points:

Given your computation and conclusions, which of the following statements is true?

When the coupon rate is greater than Liam’s required return, the bond’s intrinsic value will be less than its par value.

When the coupon rate is greater than Liam’s required return, the bond should trade at a discount.

A bond should trade at a par when the coupon rate is greater than Liam’s required return.

When the coupon rate is greater than Liam’s required return, the bond should trade at a premium

Explanation / Answer

(a)

A=Bond’s semiannual coupon payment=45

B=Bond’s par value=1000

C=Semiannual required return=5.25%

(b)

Intrinsic Value=45/(1.0525^1)+45/(1.0525^2)+45/(1.0525^3)+45/(1.0525^4)+45/(1.0525^5)+45/(1.0525^6)+1000/(1.0525^6)=962.23

So it is unreasonable that the intrinsic bond value will be higher tha 1000.

(c) Intrinsic Value=35/(1.025^1)+35/(1.025^2)+35/(1.025^3)+35/(1.025^4)+35/(1.025^5)+35/(1.025^6)+1000/(1.025^6)=1055.08

(d) When the coupon rate is greater than Liam’s required return, the bond should trade at a premium.

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