Overview
Assessment 6
Respond to four questions and solve three computational problems related to valuation of bonds.
By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:
• Competency 2: Define finance terminology and its application within the business environment.
o Define a discount bond and a premium bond.
o Describe the relationship between interest rates and bond prices.
o Describe the differences between a coupon bond and a zero coupon bond.
o Calculate the yield to maturity on a coupon bond.
o Calculate the price of a zero coupon bond.
o Calculate the price of a coupon bond.
• Competency 3: Evaluate the financial health of an organization.
o Explain what a call provision enables bond issuers to do.
o Explain why bond issuers would exercise a call provision.
Assessment Instructions
Respond to the questions and complete the problems.
Questions
In a Word document, respond to the following. Number your responses 1–4.
1. Explain what a call provision enables bond issuers to do. Why would bond issuers exercise a call provision?
2. Define a discount bond and a premium bond. Provide examples of each.
3. Describe the relationship between interest rates and bond prices.
4. Describe the differences between a coupon bond and a zero coupon bond.
Use references to support your responses as needed. Be sure to cite all references using correct APA style. Your responses should be free of grammar and spelling errors, demonstrating strong written communication skills.
Problems
In either a Word document or Excel spreadsheet, complete the following problems.
• You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet.
• If you choose to solve the problems algebraically, be sure to show your computations.
• If you use a financial calculator, show your input values.
• If you use an Excel spreadsheet, show your input values and formulas.
In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer.
Compute the following:
1. Assuming semi-annual compounding, what is the price of a zero coupon bond that matures in 3 years if the market interest rate is 5.5 percent? Assume par value is $1000.
2. Using semi-annual compounding, what is the price of a 5 percent coupon bond with 10 years left to maturity and a market interest rate of 7.2 percent? Assume that interest payments are paid semi-annually and that par value is $1000.
3. Using semi-annual compounding, what is the yield to maturity on a 4.65 percent coupon bond with 18 years left to maturity that is offered for sale at $1,025.95? Assume par value is $1000.
Suggested Resources-
The following optional resources are provided to support you in completing the assessment or to provide a helpful context.
Library Resources:
• Weaver, S. C., & Weston, J. F. (2001). Finance and accounting for nonfinancial managers. New York, NY: McGraw-Hill.
• Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: American Management Association.
Course Library Guide
You are encouraged to refer to the resources in the BUS-FP3062 – Fundamentals of Finance Library Guide to help direct your research.
Other Resources
• Cornett, M., Adair, T., & Nofsinger, J. (2019). M: Finance (4th ed.). New York, NY: McGraw-Hill. Available in the courseroom via the VitalSource Bookshelf link.
Valuation Of Bonds
1.
A call provision is a clause used by bond issuers during the formation of a bond contract. This clause stipulates the ability of a bond issuer to redeem a bond before it matures. In essence, the call provision calls enable a bond issuer to repurchase debt security and retire a debt before the agreed-upon maturity date. During the bond retirement, the bond issuer pays the investors the accrued interest based on the provisions of the recall date. However, it is worth noting bond issuers can only exercise a call provision on callable bonds. Literature suggests a few reasons why bond issuers would exercise a call provision, including to avoid the loss stemming from declining stock prices and market interest rates (Zhang, 2016). Notably, when the market interest rates drop below the rate being paid on the bond, a bond issuer becomes better positioned to refinance the debt. Therefore, the issuer may choose to redeem the bond at a lower coupon rate.
Often, bonds are issued as debt instruments meaning that the bondholders receive a specific interest for buying the bonds. Bond issuers can issue their bonds at different rates, including at a discount and premium. Scholars define discount bonds as bonds sold at an amount less than the bond’s face value (“Valuing bonds,” n.d.). Therefore, the bond issuer receives an amount lower than the bond’s face value in the market. For example, suppose a bond’s face value is $1,500, and a business sells it for $1,000, it is said to be a discount bond. On the other hand, a premium bond is a bond sold for an amount greater than the bond’s value (“Valuing bonds,” n.d.). For example, suppose a bond’s face value is 1,000, and the market value is $800, it is a premium bond.
Mobius (2012) states that interest rates and bond prices are inversely related. When the rates rise, the bond prices begin to fall. Conversely, when the interest rates decline, the bond prices increase. This interrelationship mainly stems from the competition in the capital market. For example, suppose an investor holds a bond that yields interest at 5 per cent. New market bonds are likely to be issued at a higher interest rate to attract investors. In this scenario, new bonds may be issued at 8 per cent. With the rise in interest rates, the old bonds become less attractive because they generate lower interest income than the new instruments. Therefore, the old investors would be willing to sell their bonds to buy those that yield higher interest. However, it is worth noting that other investors may be unwilling to purchase a bond with a lower interest income considering the availability of other bonds. Therefore, the old bonds’ market becomes scarce, and investors are forced to sell them at relatively lower prices to attract buyers.
Similarly, new bonds are less likely to earn a lower interest income when the interest rates fall. The older bonds become more attractive, and individuals would be more willing to buy the older bonds to earn higher interest rates. Therefore, older investors sell their bonds for higher prices because of the growing market for the instruments.
The primary difference between a coupon bond and a zero-coupon bond is the issuance of interest. On the one hand, zero-coupon bonds do not offer interest payments to bondholders while coupon bonds provide coupon payments to investors at a given rate.
References
“Valuing bonds” (n.d.). Lumen Learning. https://courses.lumenlearning.com/boundless-accounting/chapter/valuing-bonds/
Mobius, M. (2012). Bonds: An introduction to the core concepts. John Wiley & Sons.
Zhang, B., & Zhao, D. (2016). The pricing of convertible bonds with a call provision. Journal of Applied Mathematics and Physics, 4(1), 1124-1130. https://www.researchgate.net/deref/http%3A%2F%2Fdx.doi.org%2F10.4236%2Fjamp.2016.46117
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