Fixed Income Valuation Case Study Solution

Problem No. 1:

Solution to Part A: The Yield to Maturiy to this question is 4.75%. This doesn't need calculations as the bond is priced at par an
par, YTM will be equal to Coupon which is 4.75% in the present case.
If the bonds are priced at 99 or 101 instead of 100 illustrates the invesre relationship between price and
securities. The Yield computations are given below:

If the bond is priced at 99: YTM = 4.88%

If the bond is priced at 101: YTM = 4.62%

Solution to Part B: Part B of the question is to compute the price, instead of Yield, and to do so under the assumption of few
and lower required yield (3%).
The bond pricing forumula to compute the price is given by

Price = 4.75/(1.03) + 4.75/(1.03)^2 + 4.75/(1.03)^3 +…………….+ 104.75/(1.03)^8 which turns out to be 11

Discounted
Period Cash Flows Discount Factor Cash Flows
1 4.75 0.971 4.612
2 4.75 0.943 4.477
3 4.75 0.915 4.347
4 4.75 0.888 4.220
5 4.75 0.863 4.097
6 4.75 0.837 3.978
7 4.75 0.813 3.862
8 104.75 0.789 82.691
Bond Price = 112.284
ase Study Solution

as the bond is priced at par and if the bond is priced at

elationship between price and yield for fixed income s

o under the assumption of fewer years to maturity (8 years)

03)^8 which turns out to be 112.28

 Fixed Income Valuation Case Study Solution

Problem No. 2:

Solution to Part A: This problem is almost similar to Problem No. 1, where we need to estimate prices and yields on fixed in
different frequencies in coupon payments, including annual, semi-annual, amd zero-coupon payments.
You need to understand the difference between "Bond-equivalent (nominal) yield" versus "Effective Ann
this question.
The Bond-euivalent yield is simply twice the semi-annual yield and ignores compounding. This is the con
The Effective annual yield, in contrast, is computed by assuming that the semi-annual coupon received in
the same semi-annual rate during the second half of the year. For Patriot's bonds, their bond equivalent
Effective annual yield is given the by the formula (1 + i/2)^n. In this case it is =

Using Bond pricing formula for a semi annual coupon paying bond shown below, we can compute the bo

Bond Price = 45/(1+0.04) + 45/(1 + 0.04)^2 +……..+ 1045/(1.04 )^10

Discounted
Period Cash Flows Discount Factor Cash Flows
1 45 0.96 43.27
2 45 0.92 41.61
3 45 0.89 40.00
4 45 0.85 38.47
5 45 0.82 36.99
6 45 0.79 35.56
7 45 0.76 34.20
8 45 0.73 32.88
9 45 0.70 31.62
10 1045 0.68 705.96
Bond Price of Bond A= 1040.55

In the same way, the price of Bond B is 1000 and that of Bond C is 456.39

Solution to Part B: This question can be solved by observing that the Nationaliste Eurobond has the same dollar coupon as B
Bond B. In this case, even though the Eurobond is trading at discount at a discount it is not a better deal
The Nationaliste bond has a yield of 8.15%. This is essentially identical to the 8.16% effective annual yield
same effecive yield as the Eurobond despite being priced at par because it provides a semi-annual coupo
additional returns that make the effective annual yield in Bond B equivalent ti that of the discounted Eur
Hence, when comparing bonds with different compouding frequencies, the yields of the bonds must be p
effective annual yield or a bon-equivalent yield (nominal yield) before making comparison.
Case Study Solution

te prices and yields on fixed income securities, but introduces

amd zero-coupon payments.
al) yield" versus "Effective Annual Yield" before proceeding to answer

compounding. This is the convention used for quoted yields.

emi-annual coupon received in the first half of the year is reinvested at
s bonds, their bond equivalent yiled is 8% (4% x 2) and their
0.0816 8.16%

below, we can compute the bond price of Bond A:

as the same dollar coupon as Bond B but sells at a 1% discount compared to

discount it is not a better deal compared to Bond B due to the following:
he 8.16% effective annual yield on Bond B. This is so because Bond B has the
provides a semi-annual coupon . Reinvestment of the coupon provides the
nt ti that of the discounted Eurobond, which has an annual coupon.
e yields of the bonds must be placed on a common basis - either an
king comparison.
 Fixed Income Valuation Case Study Solution
Problem 3: This problem discusses amortizing debt instruments, mortgages in particular. The primary differences be
debt versus the bond debt is that in mortgage, prinicpal amortized over the life of the instrument rather
loan. Second, mortgage payments are generally level cash amounts (EMIs) in which the principal and inte
Specifically, the interest portion of EMI payments is high in the early periods while prinicpal payments ar
reverse by the end of the mortgage when most of the payment is principal.

Solution to Part A: The present value of the mortgage for a $25000 annuitites at an yield of 9% for 20 years is $228214 (By u
But, the borrower will ultimately pay $500000 in total over 20 years, the total interest paid will be $2717
The computations for amortization schedule is shown below:

Year EMI Int. Comp Prin. Comp O/S Principal

0 228214
1 25000 20539 4461 223753
2 25000 20138 4862 218891
3 25000 19700 5300 213591
4 25000 19223 5777 207814
5 25000 18703 6297 201518
6 25000 18137 6863 194654
7 25000 17519 7481 187173
8 25000 16846 8154 179019
9 25000 16112 8888 170131
10 25000 15312 9688 160442
11 25000 14440 10560 149882
12 25000 13489 11511 138371
13 25000 12453 12547 125825
14 25000 11324 13676 112149
15 25000 10093 14907 97243
16 25000 8752 16248 80994
17 25000 7289 17711 63284
18 25000 5696 19304 43979
19 25000 3958 21042 22938
20 25000 2064 22936 0
Total 500000 271788 228212

From the above table, in the first year the interest paid will be $20539 (=0.09 x $228214). It follows that
20539). After 19 years of payments, the borrower will have repaid $205278 of the principal. Therefore, t
principal and $2064 as interest.

Solution to Part B: The question in Part B should be worked in the same way as iillustrated above, but in this case the annua
five years. Hence, in this case this discountin these cash flows to the present using 9% rate provides a va
se Study Solution
ular. The primary differences between conventional mortgage
he life of the instrument rather than repaid at the end of the
s) in which the principal and interest proportions change over time.
ods while prinicpal payments are small. These relative proportions

9% for 20 years is $228214 (By using present value of Annuities formula)

total interest paid will be $271786 (=$50000 - $228214)

0.09 x $228214). It follows that principal repayment is $4461 ($25000-

78 of the principal. Therefore, the final payment will conssit of $22936 as

bove, but in this case the annual payments are rised every year every
ent using 9% rate provides a value of $273302.
 Fixed Income Valuation Case Study Solution

Problem 4:

Solution to Part A and Part B: The effective annual yield to maturity and final payments required on the two privately place

Quoted Annual
Bond
Rate
Pru-Johntower 10.00%
Tom Paine 9.72%

Both are zero-coupon bonds, but with different frequencies for the computations of feffectiv
the Pru-Johntower's bond can be deduced immediately as 10% as it is structured to pay a 10
its effective annual yield is simply 10%. Estimating the yield on the Tom Paine bond requires
annual yield of 9.72% will be compounded monthly. Its effective annual yield is, therefore:
YTM = (1 + (0.0972/12)^12) = 10.16%

Solution to Part C: As the reinvestment risk is present for the coupon paying bond, investors expect a higher yei
zero-coupon bond with the same risk characterisitcs.
Valuation Case Study Solution

ayments required on the two privately placed bonds are summarized below:

Effective Annual
Final Payment ($)
Yield to Maturity
10.00% 41772000
10.16% 42722000

requencies for the computations of feffective annual yields. The effective annual yield on
diately as 10% as it is structured to pay a 10% annual yield with no re-investment risk, hence,
ng the yield on the Tom Paine bond requires some calculation. This is because the quoted
hly. Its effective annual yield is, therefore:
TM = (1 + (0.0972/12)^12) = 10.16%

n paying bond, investors expect a higher yeild from coupon paying bonds compared to
 Fixed Income Valuation Case Study Solution

Problem 5:

Solution to Part A: The effective after-tax cost to McDonald's of the notes described in the problem is 4.35%. Th
(1+(0.06625/2) x (1-0.35))^2 = 1.0435
The deductibility of interest expense for tax purpose lowers the actual out-of-pocket (i.e., aft

Solution to Part B: Part B requires to examine the actual dollar amount of tax shield generated by the deductibl
compute its present value. The semi-annual tax shield from interest expense on these notes
0.35*(0.06625/2) * 150 million = $1.7
Discounting the tax shield calculated above at the after-tax cost of debt of 4.30625% results
of $28 million.
Valuation Case Study Solution

notes described in the problem is 4.35%. The computation is given below:

(1+(0.06625/2) x (1-0.35))^2 = 1.0435 = 4.35%
ose lowers the actual out-of-pocket (i.e., after-tax) cost of debt.

unt of tax shield generated by the deductible interest expense on McDonald's notes and
hield from interest expense on these notes (in million dollars) is
0.35*(0.06625/2) * 150 million = $1.739 million
e after-tax cost of debt of 4.30625% results in a somewhat larger present value of tax shields