What is the value of bonds and the interest rate fluctuations for the Garraty Company?
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The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual interest plus $1,000 at maturity. Bond L has a maturity of 15 years, and Bond S a maturity of 1 year.
a. What will be the value of each of these bonds when the going rate of interest is (1) 5 percent, (2) 8 percent, and (3) 12 percent? Assume that there is only one more interest payment to be made on Bond S.
b. Why does the longer-term (15 year) bond fluctuate more when interest rates change than does the shorter-term bond (1 year)?
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Solution Summary
The solution shows all the calculations for the value of bonds with differing interest rates as listed in the problem.
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(a) We use the formula VB = PMT * [1 - 1 ¸ (1 + k)n] ¸ k + M ¸ (1 + k)n
(1) k = YTM = 5%, n = 15 for long bond (L), and n = 1 for short bond (S), PMT = $100, M = $1000, PV = VB?
VL = $100 * [1 - 1 ¸ (1.05)15] ¸ 0.05 + $1000 ¸ (1.05)15 = $100 * 10.3797 + $1000 *(0.4810) = $1518.97. Also, using a financial function, we have N = 15, I = 5, PMT = 100, FV = 1000, PV = ? = -1518.9829. So, VL = $1518.98.
VS = $100 * [1 - 1 ¸ ...
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