The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual

Question

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. 1.What will be the value of each of these bonds when the going rate of interest is 6%? Assume that there is only one more interest payment to be made on Bond S. Round your answers to the nearest cent. Bond L $ Bond S $ 2.What will be the value of each of these bonds when the going rate of interest is 8%? Assume that there is only one more interest payment to be made on Bond S. Round your answers to the nearest cent. Bond L $ Bond S $ 3.What will be the value of each of these bonds when the going rate of interest is 15%? Assume that there is only one more interest payment to be made on Bond S. Round your answers to the nearest cent. Bond L $ Bond S $ b.Why does the longer-term bond's price vary more when interest rates change than does that of the shorter-term bond? -Select-IIIIIIItem 7 I. Longer-term bonds have more reinvestment rate risk than shorter-term bonds. II. Shorter-term bonds have more interest rate risk than longer-term bonds. III. Longer-term bonds have more interest rate risk than shorter-term bonds.

Explanation / Answer

The value of a bond in business school terms is the net present value (NPV) of future cash flows, discounted at a certain rate, which in this case would be what you have called the going rate of interest. If you have a financial calculator or program such as Excel, you can enter the cash flows at the particular times when they come. So at the end of Year 1 you'd have a $100 positive cash flow. In the case of Bond S you'd also have the $1,000 final payment. So you enter 1100 and have the program calculate the NPV of 1100 in one year at the various interest rates. It's not difficult, easy enough that I quickly ran the results in Excel below. Bond L would have Year 1 100, Year 2 100, etc, until Year 15 1100. Request the NPV of this "income stream" using the various interest rates and you'll have your answer. For S: 5%: 1,047.62 8%: 1,018.52 12%: 982.14 For L: 5%: 1,518.98 8%: 1,171.19 12%: 863.78

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