Determination of Bond Price and Sensitivity to Interest Rate Changes

This document discusses the determination of bond price for two bonds with different maturity dates. It also explores the sensitivity of bond price to changes in interest rates, highlighting the impact of maturity period. The document includes formulas and calculations for bond pricing and dividend valuation.

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Question 4
(a) The determination of the bond price is as shown below.
Bond 1: Maturity Date: 1st April, 2022
The key parameters of this bond are specified below.
Par value = $ 100,000
Interest rate = 10% p.a.
Coupon rate = 8% paid semi-annually
Coupon paid by the bond = (8/100)*(100000/2) = $ 4,000 every six months
Time to maturity = April 1, 2019 to April 1, 2022 or 3 years which amount to 6 semi-annual
periods.
The price of this bond as on April 1, 2019 would be the discounted value of all future
payments which is shown below.
Bond 2: Maturity Date: 1st April, 2026
The key parameters of this bond are specified below.
Par value = $ 100,000
Interest rate = 10% p.a.
Coupon rate = 8% paid semi-annually
Coupon paid by the bond = (8/100)*(100000/2) = $ 4,000 every six months
Time to maturity = April 1, 2019 to April 1, 2026 or 7 years which amount to 14 semi-annual
periods.
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The price of this bond as on April 1, 2019 would be the discounted value of all future
payments which is shown below.
(b) It is known that the bonds earlier were trading at par value but as the market interest rate
has increased, there is a decrease in the price of the two bonds which is on expected lines.
However, if the extent of decline is compared across the two bonds, it is evident that bond
with a longer duration is more impacted. This leads to the conclusion that sensitivity of
the bond price to interest rate changes is higher for long maturity period bonds (Brealey,
Myers and Allen, 2014).
Question 5
(a) Based on the given data, the future dividends expected to be paid would be based on the
following formula.
Dt=D0× ( 1+g ) t
The requisite timeline summarising the above computations is shown below.
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(b) The requisite model to be used for determination of terminal value of dividends once the
constant dividend growth rate of 5% kicks in from 8th year onwards uses the following
formula (Petty et. al., 2016).
P0= D0× ( 1+ g )
( RE−g ) = D1
( RE−g )
Perpetual dividend growth rate of dividends from year 8 onwards = 5%
The current share price can be computed considering the present value of expected dividends
from year 1 to year 7 and terminal value of future dividends after that. This has been carried
out considering the given discount rate of 13%.
References
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Brealey, R.A., Myers, S.C. and Allen, F. (2014) Principles of corporate finance. 2nd ed. New
York: McGraw-Hill Inc, pp. 221
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2016)
Financial Management, Principles and Applications. 6th ed. NSW: Pearson Education, French
Forest Australia, pp. 145
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