Peter Clemenza and Luca Brasi are arguing about the following bonds. Both bonds
ID: 2798123 • Letter: P
Question
Peter Clemenza and Luca Brasi are arguing about the following bonds. Both bonds are for 5 years, each with the par value of $100,000. The coupon rates are compounded semi-annually. The coupon rate for bond #1 (favored by Mr. Clemenza) equals 1.8% and is tax free. The coupon rate for bond #2 (favored by Mr. Brasi) equals 2.6%, but it is subject to both federal and state taxes. The combination of federal and state taxes on this type of bonds usually average to about 30%. Peter Clemenza argues that since one does not have to pay taxes on bond #1, then it is a better investment. Luca Brasi says the bond #2 is a good investment, because it will earn higher return than the bond #1. Calculate the price of each bond, using level debt service bond pricing. Assume the market rate of 2.5%.
Explanation / Answer
The price of the bonds are calculated using the PV() function in excel.
The Price of bond #1 is calculated as in =PV(rate,nper,pmt,fv) where rate = 0.025/2, nper = 5*2 =10, pmt = 1.8% of 100,000 = 1800 or 900 (semi annual), the fv = par value = 100,000
The price of bond #1 =PV(0.025/2,10,900,100000,0) = $96,729.07
The Price of bond #2 is calculated as in =PV(rate,nper,pmt,fv) where rate = 0.025/2, nper = 5*2 =10, pmt = 2.6% of 100,000 = 2600 or 1300 (semi annual), the fv = par value = 100,000
The price of bond #2 =PV(0.025/2,10,1300,100000,0) = $100,467.28
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