Bond valuation You own a 20year 1000 par value bond paying 6

(Bond valuation) You own a 20-year, $1,000 par value bond paying 6.5 percent interest annually. The market price of the bond is $775, and your required rate of return is 10 percent. a. Compute the bond\'s expected rate of return b. Determine the value of the bond to you, given your required rate of return. c. Should you sell the bond or continue to own it? a. What is the expected rate of return of the 20-year, $1,000 par value bond paying 6.5 percent interest annually if its market price is $775? % (Round to two decimal places.) b. What is the value of the bond to you, given your 10 percent required rate of return? s (Round to the nearest cent) c. Should you sell the bond or continue to own it? (Select the best choice below.) A. You should sell the bond because the bond\'s yield to maturity is higher than your expected rate of return and thus it is undervalued B. You should continue to hold the bond because the bond\'s yield to maturity is higher than your expected rate of return and thus it is undervalued. C. You should sell the bond because the bond\'s yield to maturity is lower than your expected rate of return and thus it is overvalued.

Solution

a.

YTM = [Coupon payment + (Face value - Price) / No of periods] / [(Face value + Price) / 2 ]

= [$1000*6.5% + ($1000-$775)/20] / [($1000+$775)/2]

= [$65+$11.25]/$887.5

= 8.59%(approx.)

b.

                           = $702.02

c.

Answer : C

If you can earn 10% elsewhere, then sell the bond for 875 because if you hold it you will only earn 8.59%.

Value of Bond = Present Value of Interest Payments + Present Value of Principal Payment at Maturity
Present Value of Interest Payments
PVA= A x PVIFA(n=20 i=10%)
PVA= $65 x 8.51356
= $553.38
Present Value of Principal Payment at Maturity
PV = FV x PVIF (n=20, i=10%)
PV = $1,000 x 0.14864
= $148.64
Value of Bond = $553.38+$148.64
= $702.02 c. Answer : C If you can earn 10% elsewhere, then sell the bond for 875 because if you hold it you will only earn 8.59%.