# Finance P6-17 Midland Utilities, P6-22 & P6-5 U.S. Treasury securities

P6-17 Midland Utilities has outstanding a bond issue that will mature to its $1,000 par value in 12 years. The bond has a coupon interest rate of 11% and pays interest annually.

a. Find the value of the bond if the required return is

(1) 11%,

(2) 15%, and

(3) 8%.

b. Plot your findings in part a on a set of “required return (x axis)–market value of bond (y axis)” axes.

c. Use your findings in parts a and b to discuss the relationship between the coupon interest rate on a bond and the required return and the market value of the bond relative to its par value.

d. What two possible reasons could cause the required return to differ from the coupon interest rate?

P6-22 Bond – Par Value – Coupon Interest Rate – Years to Maturity – Current Value

A – $1,000 – 9% – 8 – $820

B – $1,000 – 12% – 16 – $1,000

C – $500 – 12% – 12 – $560

D – $1,000 – 15% – 10 – $1,120

E – $1,000 – 5% – 3 – $900

a.) Calculate the yield to maturity (YTM) for each bond.

b.) What relationships exist between the coupon interest rate and yield to maturity and the par value and market value of a bond? Explain.

P6-5 Nominal interest rates and yield curves: Are recent study of inflationary expectations has revealed that the consensus among economic forecasters yields the following average annual rates of inflation expected over the periods noted. (note: Assume that the risk that future interest rate movements will affect longer maturities more than shorter maturities is zero; that is, there is no maturity risk.)

Period Averages Annual rate of inflation

3 months 5%

2 years 6

5 years 8

10 years 8.5

20 years 9

a) If the real rate of interest is currently 2.5%, find the nominal rate of interest on each of the following U.S. Treaury issues: 20-year bond, 3 month bill, 2-year note, and 5-year bond.

b) In the real rate of interest suddenly dropped to 2% withouth any change in inflationary expectations, what effect, if any, would this have on your answers in part a? Explain

c) Using your findings in part a, draw a yield curve for U.S. Treasury securities. Describe the general shape and expectations reflected by the curve.

d) What would a follower of the liquidity preference the theory say about how the preferences of lenders and borrowers tend to affect the shape of the yield curve drawn in part c? Illustrate that effect by playing on your graph a dotted line that approximates the yield curve without the effect of liquidity preference.

e) What would a follower of the market segmentation theory say about the supply and demand for long-term loans versus the supply and demand for short-term loans given the yield curve constructed for part c of this problems?

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