Financial Management-Chapter 7 Solution- Gitman Essay

5883 Words Jul 21st, 2013 24 Pages
Financial Management-chapter 7 solution- Gitman

7-21

Western Money Management Inc.

Bond Valuation

Robert Black and Carol Alvarez are vice presidents of Western Money Management and codirectors of the company’s pension fund management division. A major new client, the California League of Cities, has requested that Western present an investment seminar to the mayors of the represented cities. Black and Alvarez, who will make the presentation, have asked you to help them by answering the following questions. A. Answer: What are a bond’s key features? [Show S7-1 through S7-4 here.] If possible, begin this lecture by showing students an actual bond certificate. We show a real coupon bond with physical coupons. These can no longer
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Therefore, bonds with a call provision are riskier than those without a call provision. Accordingly, the interest rate on a new issue of callable bonds will exceed that on a new issue of noncallable bonds. Although sinking funds are designed to protect bondholders by ensuring that an issue is retired in an orderly fashion, it must be recognized that sinking funds will at times work to the detriment of bondholders. On balance, however, bonds that provide for a sinking fund are regarded as being safer than those without such a provision, so at the time they are issued, sinking fund bonds have lower coupon rates than otherwise similar bonds without sinking funds.

Chapter 7: Bonds and Their Valuation

Integrated Case

3

C.

How is the value of any asset whose value is based on expected future cash flows determined?

Answer:

[Show S7-8 through S7-10 here.] 0 | PV CF1 PV CF2 1 | CF1 2 | CF2 3 | CF3


N | CFN

The value of an asset is merely the present value of its expected future cash flows: Value = PV = =
CF3 CF1 CF2 CFN    ...  2 3 1 (1  rd ) (1  rd ) (1  rd ) (1  rd )N

 (1  r t 1

N

CFt d )t

.

If the cash flows have widely varying risk, or if the yield curve is not horizontal, which signifies that interest rates are expected to change over the life of the cash flows, it would be logical for each period’s cash flow to have a different discount rate. However, it is very difficult to make such adjustments; hence it is

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