Question

Harold Reese must choose between two bonds: Bond X pays $82 annual interest and has a market value of $710. It has 10 years to maturity. Bond Z pays $88 annual interest and has a market value of $750. It has five years to maturity. Assume the par value of the bonds is $1,000.

a. Compute the current yield on both bonds.
b. Which bond should he select based on your answers to part a?
c. A drawback of current yield is that it does not consider the total life of the bond. For example, the approximate yield to maturity on Bond X is 13.44 percent. What is the approximate yield to maturity on Bond Z? The exact yield to maturity?

Answer 1

a) For Bond X = 11.55%

For Bond Z = 11.73 %

b) Bond Z

c) Approximate YTM = 15.77%

Exact yield to maturity = 16.53 %

Step-by-step explanation:

Bond X : pays $82 annual interest , market value = $710 and years to maturity =10

Bond Z: pays $88 annual interest, market value = $750 , Years to maturity= 5

par value of bonds = $1000

a) Current yield on both bonds

For Bond X : annual interest / market value = 82 / 710 = 11.55%

For Bond Z : Annual interest / market value = 88 / 750 = 11.73%

b) The Bond that should be selected = Bond Z

C) Calculate the approximate yield to maturity on Bond Z and exact yield to maturity

i) Yield to maturity on Bond Z

[C + (Par Value - Current Value) / n] / (Par Value + Current Value) / 2

where: C = 88 , par value = 1000, Current value = $750, n = 2

∴ YTM on Bond Z = 0.1577 = 15.77%

ii) Exact yield to maturity = 16.53 %