please show the step by step break down The I Corporation ha

please show the step by step break down

The I Corporation has an obligation to pay $1 million in 10 years. The want to invest money now that it will be sufficient to meet this obligation. The purchase of a zero- coupon bond would provide a solution; but such zeros are not available in the exact required maturity now. Instead the I Corporation is planning to select from the 3 corporate bonds shown below. The prices of bonds are given as percent of par. COUPON RATE(%)MATURITY(YRS)PRICE 30 10 20 YIELD(%) BOND1 6 BOND211 BOND39 69.04 113.1 100.00 Discuss how the I Corporation will choose and what is going to ultimately the bond portfolio of their choice,

Solution

This will depend upon the present and future interest rate cycles.

Scenario 1: Reducing interest rate cycle: If I corp expected the future interest rates to reduce, then the yield will also reduce and the Bond 1 would make sense. Since this bond is available at a discount, they can purchase this bond and as the interest rates fall, the price of the bond will increase and they can make the capital gain plus a fixed coupon which they will always get.

Scenario 2: Increasing interest rate cycle: If the expected future interest rate is expected to increase, then they can select Bond 2 or bond 3 since bond 1 with a 6% coupon will become less attractive.

I would suggest not to go with Bond 2 since it maturity is exactly 10 years and at the end of 10 years you will get back $100 for the $113.1 you made. So a definite capital loss will occur in case of bond 2 although you get fixed interest rate of 11%.

I would suggest the business to either choose from Bond 1 or Bond 3 based on the prevailing interest rate scenario.