The portfolio manager of Buy-Lo&Sell-Hi Company has excess cash that is to be invested for four years. He can purchase four year bonds of Groogle Company with 9 percent yield to maturity. Alternatively, he can purchase 20-year EyeBeeM Company bonds for $2.9 million that offer a par value of $3 million and an 11 percent coupon rate with annual payments. The manager expects that the required rate of return on these 20-year bonds will be 12 percent four years from now. What is the forecasted market value of the 20-year bonds in four years? Which investment is expected to provide a higher annual return over the four-year period? (show work and financial calculator inputs)
a.
What is the forecasted market value of the twenty-year bonds in four years?
ANSWER:
PV
of 20-Year…………….PVof RemainingBonds as of 4 yrars from now
= Coupon Payments +PVof Principal
= $330,000(PVIFAi= 12%,n= 16) + $3,000,000(PVIFi= 12%,n= 16)
= $330,000(6.9740) + $3,000,000(.1631)
= $2,301,420 + $489,300
= $2,790,720
b.
Which investment is expected to provide a higher yield over the four-year period?
Company could achieve a yield of 9 percent on the Treasury notes with certainty.
Bydiscounting the cash flow resulting from the alternative investment (20-year bonds) over the four-yearinvestment horizon at 9 percent, we can determine whether the bonds offer a higher or lower yield.
ThePVof the bonds as of today using a 9 percent discount rate is:
= $330,000(PVIFAi= 9%,n= 4) + $2,790,720(PVIFi= 9%,n= 4)
= $330,000(3.2397) + $2,790,720(.7084)
= $1,069,101 + $1,976,946
= $3,046,047
Since Company would pay less today for these bonds than the present value estimated here, this impliesthat the yield to maturity on the bonds exceeds 9 percent. Therefore, the bonds offer a higher yield
