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An investor must choose between two bonds: Bond A pays $90 annual interest and has a market value of $820
An investor must choose between two bonds:
Bond A pays $90 annual interest and has a market value of $820. It has 10 years to maturity.
Bond B pays $95 annual interest and has a market value of $920. It has six years to maturity.
Assume the par value of the bonds is $1,000.
a) Compute the current yield on both bonds. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
b) Which bond should she select based on your answers to part a?
multiple choice 1
- Bond A
- Bond B
c) A drawback of current yield is that it does not consider the total life of the bond. For example, the approximate yield to maturity on Bond A is 12.11 percent. What is the approximate yield to maturity on Bond B? The exact yield to maturity? (Use the approximation formula to compute the approximate yield to maturity and use the calculator method to compute the exact yield to maturity. Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
d) Has your answer changed between parts b and c of this question in terms of which bond to select?
multiple choice 2
- No
- Yes
Expert Solution
a) Computation of the current yield on both bond:-
Bond A ;
Current yield = Annual coupon payment / Current price
= $90 / $820
= 10.98%
Bond B ;
Current yield = Annual coupon payment / Current price
= $95 / $920
= 10.33%
b) Bond A has higher current yield. So, it should be selected.
c) Computation of the approximate yield to maturity on bond B:-
Approximate yield to maturity = (C+(F-P)/n) / ((F+P)/2)
= (95+(1000-920)/6) / ((1000+920)/2)
= 108.33 / 960
= 11.28%
We can calculate the exact yield to maturity on bond B by using the following formula in excel:-
=rate(nper,pmt,-pv,fv)
Here,
Rate = Exact yield to maturity
Nper = 6 periods
Pmt = $95
PV = $920
FV = $1,000
Substituting the values in formula:
= rate(6,95,-920,1000)
= 11.41%
d) No, the answer has not changed.
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