1. Consider the following bonds:

Bond Coupon Rate (annual payments) Maturity (years)

A 0% 15

B 0% 10

C 4% 15

D 8% 10

What is the percentage change in the price of each bond if its yield to maturity falls from 6% to 5%?

Which of the bonds A–D is most sensitive to a 1% drop in interest rates from 6% to 5% and why? Which bond is least sensitive? Provide an intuitive explanation for your answer.

Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 6%. You hold the bond for five years before selling it.

If the bond’s yield to maturity is 6% when you sell it, what is the internal rate of return of your investment?

If the bond’s yield to maturity is 7% when you sell it, what is the internal rate of return of your investment?

If the bond’s yield to maturity is 5% when you sell it, what is the internal rate of return of your investment?

Even if a bond has no chance of default, is your investment risk free if you plan to sell it before it matures? Explain.

2. HMK Enterprises would like to raise $10 million to invest in capital expenditures. The company plans to issue five-year bonds with a face value of $1000 and a coupon rate of 6.5% (annual payments). The following table summarizes the yield to maturity for five-year (annual-pay) coupon corporate bonds of various ratings:

Assuming the bonds will be rated AA, what will the price of the bonds be?

How much total principal amount of these bonds must HMK issue to raise $10 million today, assuming the bonds are AA rated? (Because HMK cannot issue a fraction of a bond, assume that all fractions are rounded to the nearest whole number.)

What must the rating of the bonds be for them to sell at par?

Suppose that when the bonds are issued, the price of each bond is $959.54. What is the likely rating of the bonds? Are they junk bonds?

Procter and Gamble (PG) paid an annual dividend of $1.72 in 2009. You expect PG to increase its dividends by 8% per year for the next five years (through 2014), and thereafter by 3% per year. If the appropriate equity cost of capital for Procter and Gamble is 8% per year, use the dividend-discount model to estimate its value per share at the end of 2009.

Colgate-Palmolive Company has just paid an annual dividend of $1.50. Analysts are predicting dividends to grow by $0.12 per year over the next five years. After then, Colgate’s earnings are expected to grow 6% per year, and its dividend payout rate will remain constant. If Colgate’s equity cost of capital is 8.5% per year, what price does the dividend-discount model predict Colgate stock should sell for today?