The demand curve and supply curve for a one-year corporate coupon bond with a fa

Question

The demand curve and supply curve for a one-year corporate coupon bond with a face value of $1000 and coupon rate of 5% are represented by the following equations: Demand: P = 1140-0.6BA Supply: P = 700 + Bs where P is the price of the bond, Bd is the quantity of bonds demanded, and Bs is the quantity of bonds supplied. a. b. C. What is the equilibrium price of the bond? (5 points) What is the equilibrium annual yield to maturity on these bonds? (5 points) Suppose that the corporate tax rate is reduced from 35% to 15%. In words, what will be the effect on bond supply and/or demand and why? What will be the effect on the bond's price and yield? (10 points)

Explanation / Answer

Ans a – At equilibrium, demand equals supply. Hence,

1140 – 0.6B = 700 + B

1140 – 700 = 1.6B

440 = 1.6B

B = 440 / 1.6 = 275

P = 700 + 275 = $975

Ans b – Annual yield to maturity is the returns generate if the bond is held till maturity. At equilibrium the price is $975 which means at maturity the face value of $1000 will be received with an interest of $50 which is 5% of the face value. Total returns from the bonds would be $25 + $50 = $75.

Yield to maturity at equilibrium = 75 / 975 = 7.69% round off.

Ans c – A corporate tax reduction means that the company will now pay less tax and would have more cash at their disposal after tax deductions. Corporations with more cash would now rely less on debt as they would be able to finance future projects with their own accumulated profit or retained earnings. Due to this there will be a reduction in the supply of bonds and the available bonds would have low interest offerings which will result in reduction in demand as well. The price of the bond is the present value of the future returns discounted at the interest rate paid on it. However, with the reduction of interest rates the price as well as the yield on the bonds will reduce.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.