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Chapter 5: Q9DQ (page 524)

Discuss the relationship between bond prices and interest rates. What impact do changing interest rates have on the price of long-term bonds versus short-term bonds? (LO16-2)

Short Answer

Expert verified

The bond prices and interest rates have an inverse relationship. When prices of bonds increase, the interest rates go down.

Step by step solution

01

Bonds

The term bond refers to a fixed-incomefinancial instrumentrepresenting the money invested by an investor in a corporation for generating interest income and the principal amount.

02

Relationship between interest rates and bond prices

The interest rates and bonds prices move precisely in the opposite directions. If interest rates go up in the market, then the prices of a bond will go down.

The long-term bonds are impacted more because of interest rate variations in the market. Short-term bonds’ maturity date is closer thanlong-term debts.

Long-term debts are more sensitive to interest rate changes because they contain a longer duration thanshort-term bonds.

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Most popular questions from this chapter

The Pioneer Petroleum Corporation has a bond outstanding with an \(85 annual interest payment, a market price of \)800, and a maturity date in five years. Find the following:

a. The coupon rate.

b. The current rate.

c. The yield to maturity

Walton and Company is the managing investment banker for a major new underwriting. The price of the stock to the investment banker is \(23 per share. Other syndicate members may buy the stock for \)24.25. The price to the selected dealers group is \(24.80, with a price to brokers of \)25.20. Finally, the price to the public is $29.50.

  1. If Walton and Company sells its shares to the dealer group, what will the percentage return be?
  2. If Walton and Company performs the dealer’s function also and sells to brokers, what will the percentage return be?
  3. If Walton and Company fully integrates its operation and sells directly to the public, what will its percentage return be?

Question: Barton Simpson, the chief financial officer of Broadband Inc. could hardly believe the change in interest rates that had taken place over the last few months. The interest rate on A2 rated bonds was now 6 percent. The $30 million, 15-year bond issue that his firm has outstanding was initially issued at 9 percent five years ago. Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par, and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life. Before Barton used the 8 percent call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market.

c. Now do the standard bond refunding analysis as discussed in this chapter. Is the refunding financially feasible?

Tiger Golf Supplies has $25 million in earnings with 7 million shares outstanding. Its investment banker thinks the stock should trade at a P/E ratio of 31. Assume there is an underwriting spread of 7.8 percent. What should the price to the public be?

Discuss how an underwriting syndicate decreases risk for each underwriter and at the same time facilitates the distribution process.

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