Questions: Assignment: Chapter 06 Bonds (Debt) - Characteristics and Valuation
Assume Grace wants to earn a return of 9.00% and is offered the opportunity to purchase a 1,000 par value bond that pays a 7.50% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value:
Intrinsic Value = A/(1+C)^1 + A/(1+C)^2 + A/(1+C)^2 + A/(1+C)^4 + A/(1+C)^2 + A/(1+C)^6 + B/(1+C)^6
Complete the following table by identifying the appropriate corresponding variables used in the equation.
Based on this equation and the data, it is to expect that Grace's potential bond investment will exhibit an intrinsic value less than 1,000.
Transcript text: Assignment: Chapter 06 Bonds (Debt) - Characteristics and Valuation
Assume Grace wants to earn a return of $9.00 \%$ and is offered the opportunity to purchase a $\$ 1,000$ par value bond that pays a $7.50 \%$ coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value:
\[
\text { Intrinsic Value }=\frac{A}{(1+C)^{1}}+\frac{A}{(1+C)^{2}}+\frac{A}{(1+C)^{2}}+\frac{A}{(1+C)^{4}}+\frac{A}{(1+C)^{2}}+\frac{A}{(1+C)^{6}}+\frac{B}{(1+C)^{6}}
\]
Complete the following table by identifying the appropriate corresponding variables used in the equation.
Based on this equation and the data, it is $\qquad$ to expect that Grace's potential bond investment will exhibit an intrinsic value less than $\$ 1,000$.
Solution
Solution Steps
To solve this problem, we need to calculate the intrinsic value of the bond using the given formula. The bond pays a semiannual coupon, so we need to adjust the coupon rate and the required return to a semiannual basis. The intrinsic value is the present value of the bond's future cash flows, which include the semiannual coupon payments and the par value at maturity. We will use the formula provided to compute the present value of these cash flows.
Step 1: Calculate Semiannual Rates
The bond has an annual coupon rate of 7.5% and a required return of 9%. To find the semiannual rates, we divide these values by 2:
Semiannual Coupon Rate=20.075=0.0375Semiannual Required Return=20.09=0.045
Step 2: Calculate Semiannual Coupon Payment
The semiannual coupon payment is calculated as follows:
Semiannual Coupon Payment=1000×0.0375=37.5
Step 3: Calculate Intrinsic Value of the Bond
The intrinsic value of the bond is computed using the formula for the present value of future cash flows. The bond pays 37.5 every six months for 3 years (or 6 periods), and the par value of 1000 is paid at the end of the last period. The intrinsic value IV is given by:
IV=t=1∑6(1+C)tA+(1+C)6B
Where:
A=37.5 (semiannual coupon payment)
B=1000 (par value)
C=0.045 (semiannual required return)
Calculating each term:
IV=(1+0.045)137.5+(1+0.045)237.5+(1+0.045)337.5+(1+0.045)437.5+(1+0.045)537.5+(1+0.045)637.5+(1+0.045)61000
After performing the calculations, we find:
IV≈961.316
Final Answer
The intrinsic value of Grace's potential bond investment is approximately \\(\boxed{961.316}\\).