Fixed Income Valuation
Case Solution
Problem 1:
Date of Issue: December 20, 1994
Date of maturity: December 20, 2004
Time Period = 10 Years
Coupon rate = 4.75%
Coupon payment frequency = Annually
Bond Price (BP) = At par [FV = Rs. 100 assumed]
A. Bond Price = PVs of future CFs
10
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝐵𝐵𝐵𝐵 = � + 𝐹𝐹𝐹𝐹/(1 + 𝑌𝑌𝑌𝑌𝑌𝑌)10
(1 + 𝑌𝑌𝑌𝑌𝑌𝑌)𝑛𝑛
𝑛𝑛=1
YTM = 4.75% [No calculation required, as bond is trading at par]
For BP = Rs. 99; Using excel based rate formula
YTM = 4.88% [Why YTM > 4.75%]
For BP = Rs. 101;
YTM = 4.62% [Why YTM < 4.75%]
B. Year 1996;
Time to maturity = 8 years
YTM = 3%
Using excel based PV function; BP = Rs. 112.28 [Why BP > FV]
Problem 2:
Part A
Investment = USD 1, 000,000
Coupon payment frequency = semi-annually
FV = USD 1,000
Bond equivalent Yield (BEY) = 8% => periodic rate of 4%
Bond A
Coupon rate = 9% => Coupon of USD 45 every six-month
Time-to-maturity = 5 years => 10 coupon payments
Using excel based PV function; BP = USD 1040.55 [Why BP > FV]
1
Bond B
Coupon rate = 8% => Coupon of USD 40 every six-month
Time-to-maturity = 10 years => 20 coupon payments
Using excel based PV function; BP = USD 1,000 [Why BP = FV]
Bond C
Zero-coupon bond
Time-to-maturity = 10 years
Using excel based PV function; BP = USD 456.39
Part B
For Euro-bond
Investment = USD 1, 000,000
Coupon payment frequency = Annually
Time-to-maturity = 10 years => 10 coupon payments
FV = USD 1,000 => BP = USD 990 (1% discount)
Using excel based rate function; Rate (annual) = 8.15%
Patriot’s bond rate (semi-annual) = 4%
Effective annual return = (1+4%) ^2 – 1 = 8.16% > Eurobond’s return (8.15%)
Problem 3:
Mortgage period = 20 years
Interest rate (fixed) = 9%
Instalment frequency = Annually
Instalment payment (PMT) = USD 25,000 (pre-tax)
Part A
Using excel based PV function; Mortgage Loan value (LV) = USD 228,214
Total amount paid in 20 years = USD 25,000 * 20 = USD 500,000
Total Interest paid = USD 271,786
Year 1
Interest paid in year 1 = LV * 9% = USD 20,539
Principal component in year 1 = USD 4,461
Year 20
Instalment year 20 = 25,000 = Principal t = 20 * (1 + 9%)
Principal t = 20 = USD 22,936
Interest t = 20 = USD 2,064
2
Part B
Instalment payments (frequency annually)
1st 5-year = USD 25,000
2nd 5-year= USD 30,000
3rd 5-year= USD 35,000
4th 5-year= USD 40,000
5 10 15 20
25,000 30,000 35,000 40,000
𝐿𝐿𝐿𝐿(𝑛𝑛𝑛𝑛𝑛𝑛) = � + � + � + �
(1 + 𝑟𝑟)𝑛𝑛 (1 + 𝑟𝑟)𝑛𝑛 (1 + 𝑟𝑟)𝑛𝑛 (1 + 𝑟𝑟)𝑛𝑛
𝑛𝑛=1 𝑛𝑛=6 𝑛𝑛=11 𝑛𝑛=16
LV (new) = USD 273,302
Problem 4:
Debt received = USD 10,000,000
Payment due in 15 years (lump sum payment)
Part A & Part B
Pru-Johntower – Annual rate of interest of 10%
Effective annual rate = 10%
Future payment = USD 10 million * (1 + 10%) ^15 = USD 41.772 million
Tom Paine MLI – Interest rate of 9.72% per year, compounded monthly
Effective annual rate = (1 + 9.72%/12) ^12 – 1 = 10.165%
Future payment = USD 10 million * (1 + 10.16%) ^15 = USD 42.722 million
Part C
Default Risk of coupon bond < default risk of zero-coupon bond
Re-investment risk of coupon bond > re-investment risk of zero-coupon bond
However, as stated in the problem, both bonds (coupon & zero-coupon) have similar
default risk. Hence, decision shall be based on re-investment risk only.
As coupon bond have higher re-investment risk compared to no-coupon (zero-coupon)
bond, hence expected (required) return shall be higher for coupon bearing bond.
3
Problem 5:
Bond Issue date = September 1995; Maturity date = 2005
Time period = 10 Years
Bond value = USD 150 million
Coupon rate = 6.625% per annum
Coupon payment frequency = Twice a year (semi-annually)
Coupon Payment (per six-month) = USD 33.125 [FV = USD 1,000]
Corporate Tax rate = 35%
Part A
Periodic rate (pre-tax) = 6.625%/2 = 3.3125%
Periodic rate (Post-tax) = 3.3125% * (1 – 35%) = 2.153%
Effective annual rate (post-tax) = (1 + 2.153%) ^2 – 1 = 4.352%
Note: Why post-tax periodic rate is used for effective annual rate (post-tax) calculation?
Reason: Post-tax effective annual rate calculation using pre-tax effective annual rate
also includes interest expense (income) on the tax-shield amount, which should be
excluded from the total interest expense (income).
Post-tax periodic rate should be used for post-tax effective annual rate calculation, as
total expense (income) excludes expense (income) generated out of tax-shield
component.
Part B
Interest payment (per 6-month) = USD 150 million * 3.3125% = USD 4.96875 million
Interest-tax shield = USD 4.96875 million * 35% = USD 1.739 million
Tax shield = USD 1.739 million (every six-month)
Time = 10 years = 20 periods (of six-month)
Discount rate (periodic) = 3.3125% [Why pre-tax rate?]
Using excel based PV formula;
PV of Interest-tax shield = USD 25.14 million
4
Problem 6:
Bond Issue date = Late 1993; Bond maturity date = Late 2023
Time length = 30 Years
Bond value = USD 50 million
IRB bond (Tax-free):
BEY = 5.65%
Coupon payment = Semi-annually (Period = 60)
Periodic interest rate = 5.65%/2 = 2.825%
Coupon = USD 28.25 (every six-month) [FV = USD 1,000]
Corporate bond (Taxable):
BEY = 7.25%
Coupon payment = Semi-annually (Period = 60)
Periodic interest rate = 7.25%/2 = 3.625%
Coupon = USD 36.25 (every six-month) [FV = USD 1,000]
Part A
Investors are concern about post-tax return. As returns from corporate bond are taxable
in the hand of recipients, it (taxable bonds) shall have higher pre-tax expected return.
For an investor to be indifferent,
3.625% * (1 – Personal Tax rate) = 2.825%
=> Personal Tax rate = 22%
Part B: [Corporate tax rate = 35%]
IRB Bond
Interest Payment (per six-month)
= USD 50 million * 2.825% = USD 1.4125 million
After-tax Interest-expense = USD 0.918 million; [1.4125 * 65%]
Corporate Bond
Interest Payment (per six-month)
= USD 50 million * 3.625% = USD 1.8125 million
After-tax Interest-expense = USD 1.178 million; [1.8125 * 65%]
Interest-expense saved (post-tax) = USD 0.260 million [1.178 – 0.918]
Discount rate (periodic) = 3.625%
Using excel based PV formula;
PV of total interest-expense saved = USD 6.326 million