A. The key features of a bond include coupon, face value, coupon rate and maturity.

The regular interest payments that a company promises to pay are called the bonds coupons. The face value or par value is the amount that will be repaid after the bond matures. The coupon rate is a percentage of the face value which determines the coupon payment. The annual coupon divided by the face value is the called the coupon rate on a bond. The number of years until the face value is paid is called the time to maturity of the bond.

B. Call provision allows a particular company to call or repurchase all or part of the bond issue at a certain period of time. Sinking fund provision allows a company to manage an account for the purpose of repaying the bonds. Instead of paying the face value to the bondholders at the end of the maturity period, which results in a huge cash outflow in that particular business year, the bond issuer can pay parts of the principle i.e. face value along with the regular coupon payments. This results in flexibility for the bond issuing company. In case of call provisions, the bond becomes more risky since the bonds can be called by the bond issuer any time. This makes the bond risky and thus it has a higher interest rate for bearing such risk. On the other hand, sinking fund provisions make a bond less risky since it ensures orderly payments to the bondholders. Therefore, sinking fund bonds have lower interest rates due to the reduced amount of risk involved in comparison to the callable bonds.

C. The value of any asset (for e.g. bonds) based on expected future cash flows can be determined by calculating the present value of its future cash flows. The interest payments (which are coupon payments in case of bonds) and the principle amount (which is the face value in case of bonds) can both be discounted back to the present value using a discount rate. This discount rate is always the required rate of return or the market interest rate which are available on other similar investments in the market.

D. In order to determine the value of a bond, we would require the face value, the number of periods remaining for maturity, the coupon and the required rate of return by the bondholders, which is also called the market interest rate or yield to maturity (YTM). By using all these, the present value of the coupon payments and the face value (which is a lump sum amount) can be determined. Face value (FV) = $1,000 Time remaining to maturity(n)= 10 Coupon rate(CR)= 10% YTM(i)=10% Coupon payment(PMT)= FV X CR = $1,000 X 10% = $100

PV of the bond= PMT (PVIFAi,n) + = 100 [(1-1/(1+0.10)10)/0.10] + [1,000 /(1+0.10)10] = 614.46 + 385.54 = $1,000 E-1. Face value (FV) = $1,000 Time remaining to maturity (n) = 10 Coupon rate (CR) = 13% YTM (i) = 10% Coupon payment (PMT) = FV X CR = $1,000 X 13% = $130

PV of the bond = PMT (PVIFA i, n) + = 130 [(1-1/(1+0.10)10)/0.10] + [1,000 /(1+0.10)10]

= 798.79 + 385.54 = $ 1,184.33 Now this bond has become a premium bond since the coupon rate (13%) is greater than the required rate of return i.e. YTM (10%) and thus the value of the bond is more than the face value of $1,000. E-2. Face value (FV)= $1,000 Time remaining to maturity(n)= 10 Coupon rate(CR)= 7% YTM(i)= 10% Coupon payment(PMT)= FV X CR= $1,000 X 7%= $70

PV of the bond= PMT (PVIFA i,n) + = 70 [(1-1/(1+0.10)10)/0.10] + [1,000 /(1+0.10)10] = 430.12 + 385.54 = $ 815.66 This bond has turned into a discount bond since the coupon rate (7%) is less than the required rate of return i.e. YTM (10%) and the value of the bond is less than the face value of $1,000.

E-3. If the required rate of return remains at 10%, the values of the 7%,10% and 13% coupon bonds would turn into the face value of $1,000 as it reaches the end of the maturity period of 10 years. In other words, the values of both the discount and premium bonds would become $1,000.

F-1. Face value (FV)= $1,000 Time remaining to maturity(n)= 10 Coupon rate(CR)= 9% PV of the bond= $887 Coupon payment(PMT)= FV X CR

= $1,000 X 9% = $90

PV of the bond= PMT (PVIFA i,n) +

887= 90 (PVIFA i,10) +

Interpolation method: Assuming YTM = 11%

PV of the bond = PMT (PVIFA i,n) + = 90 [(1-1/(1+0.11)10)/0.10] + [1,000 /(1+0.11)10] = 530.03 + 352.18 = $ 882.21

Now, assuming YTM=7%

PV of the bond = PMT (PVIFA i,n) + = 90 [(1-1/(1+0.07)10)/0.10] + [1,000 /(1+0.07)10] = 632.12 + 508.35 = $ 1,140.47 Difference = $1,140.47 - $ 882.21 = $ 258.26 $258.26 ---$1 ---4%

Working with YTM=11%, PV= $ 882.21 Difference = $ 887 - $ 882.21 = $ 4.79 $1 $ 4.79 ------=0.07% X 4.79

YTM= 11% - 0.07% = 10.93%

If the selling price is $ 1,134.20:

1,134.20= 90 (PVIFA i,10) +

Assuming YTM=11% PV of the bond= $ 882.21

Assuming YTM=7% PV of the bond= $ 1,140.47

Difference= $1,140.47 - $ 882.21 = $ 258.26 $258.26 $1 ------4%

Working with YTM =11%, PV = $ 882.21 Difference = $ 1,134.20 - $ 882.21= $ 251.99

$1 $ 4.79

------= 3.90% X 251.99

YTM = 11% - 3.90% = 7.10% For discount bonds, the coupon rate is less than the YTM or the required rate of return. In case of premium bonds, the coupon rate is greater than the YTM.

F-2. Current yield = Annual coupon payments X 100 Current market price = = 10.15%

Capital gains yield = Ending price Beginning price X 100 Beginning price = = 12.74% Total return = Current yield + Capital gains yield = 10.15%+12.74%

= 22.89%

G. Price risk is the risk involved when the required rate of returns i.e. YTM increases resulting in a decrease in the price of the bond. There is an inverse relationship between the YTM and the price of the bond. A 10 year bond has more risk since a longer maturity period makes a bond riskier.Long-term bonds have greater duration than short-term bonds. Thus, a given interest rate change will have greater effect on long-term bonds than on short-term bonds. H. Reinvestment is the risk involved when the required rate of returns i.e. YTM decreases resulting in an increase in the price of the bond. When the YTM falls well below, the bonds will be called back. The income of the bondholder would decline as the coupon payments would be stopped. If the bondholder invests in alternative sources, interest rate would be too low which would resultin a low investment return. A longer maturity period makes a bond more risky, but it yields a higher return on the bond. A short-term bond has more reinvestment risk compared to a long-term bond. Thus, a 1 year bond has more reinvestment risk since the payment at the end i.e. face value will be highly affected by significant interest rate changes. I. Some adjustments are required if semiannual payments are made. Firstly, the coupon payments have to be divided by two since there would be two coupon payments within one year. Secondly, the interest rate or the required rate of return (YTM) would also have to be divided by two because of two coupon payments within one year. Lastly, the number of periods left to maturity will have to be doubled due to two coupon payments being made each year. Face value (FV) = $1,000 Time remaining to maturity (n) = 10 X 2 = 20 Coupon rate(CR) = 10/2= 5% YTM(i) =13/2= 6.5% Coupon payment (PMT) = FV X CR = $1,000 X 5% = $50

PV of the bond= PMT (PVIFA i, n) + = 50 [(1-1/(1+0.065)20)/0.05] + [1,000 /(1+0.065)20] = 550.93 + 283.80 = $ 834.73

J. For annual payment bond:

EAR = = [{1 + (0.1/1)}^1] - 1 = 0.1 = 10% For semi - annual payment bond:

EAR = = [{1 + (0.1/2)}^2] - 1 = 0.1025 = 10.25% From the above calculations we can see that the semi-annual payment bond gives a higher EAR compared to the annual payment bond. Since the risk is same for both the bonds, investors would prefer the one which gives higher return. Therefore, the semi-annual bond is prefered.

If $1000 is the proper price of the bond then interest rate would be considered at 10.25%. Therefore the value of the annual bond would be: Face value (FV) = $1,000 Time remaining to maturity (n) = 10 Coupon rate (CR) = 10% YTM (i) =10.25%

Coupon payment (PMT) = FV X CR = $1,000 X 10% = $100

PV of the bond = PMT (PVIFA i, n) + = 100 [(1-1/(1+0.1025)10)/0.1025] + [1,000 /(1+0.1025)10] = $607.91 + $376.89 = $984.8 K. 1. Coupon Rate = 10% n = 4 years FV = $1050 PV = $1135.90 Let YTC = 5% PMT = $1000 x 10% = $50 2

PV of the bond = PMT (PVIFA i, n) + = 50 [(1-1/(1+0.025)8)/0.025] + [1,050 /(1+0.025)8] = $358.51 + $861.78 = $ 1220.29

Let YTC = 10%

PV of the bond = PMT (PVIFA i, n) + = 50 [(1-1/(1+0.05)8)/0.05] + [1,050 /(1+0.05)8]

= $323.16 + $710.68 = $1033.84 Difference = $1220.29 - $ 1033.84 = $ 186.45

Using the values for when YTC = 10%: Difference between PV of bond = $1135.9 - $1033.84 = $ 102.06 We can say: $186.45 --------- 5% $1 --------- 5/186.45 Therefore: $ 102.06 -------- [(5 x 102.06)/186.45] = 2.74% When PV = $1033.84, YTC = 10% When PV = $ 1135.9 YTC = 10% - 2.74% = 7.26%

2. Investors are more likely to earn YTC if the bond is bought because the company is more likely to call these bonds for the following reasons: a. If the company calls back these bonds then they could raise money by selling new bonds which pay 7.26% instead of the original coupon rate of 10%. b. For the above reason investors are likely to earn a YTC of 7.26% rather than a YTM of 8%.

L. The yield to maturity is the rate of return earned on a bond if it is held till maturity. It is the bonds promised rate of return, which is the return that investors will receive if all the promised payments are made. The yield to maturity equals the expected rate of return only if:

1) The probability of default is zero. 2) The bond cannot be called. For bonds where there is some default risk, or where the bond may be called, there is some probability that the promised payments to maturity will not be received, in which case, the promised yield to maturity will differ from the expected return. n) Bond ratings are concerned only with the possibility of default. Bond ratings are constructed from information supplied by the corporation. This information includes debt management using key financial ratios and financial performance by analyzing revenues and expenditure trends. Thus ratios, mortgage provisions, stability, product liability, accounting policies, etc all determine a companys bond rating. o) It would depend since if the company can be saved then it can continue by reorganizing itself. If this is the case then the bondholders would be receiving their promised payments. However, if the company cannot be saved in any way then it must be liquidated and in this case the bondholders would not be receiving all of their promised payments.