You have just noticed in the financial pages of the local newspaper that you can buy a bond (R1,000 par) for R800.If the coupon rate is 10 percent, with annual interest payments, and there are 10 years to maturity, should you make the purchase if your required return on investments of this type is 12 percent?

Question

Quizplus · Accepted Answer

To determine whether or not to make the purchase, we need to calculate the bond's yield to maturity (YTM) and compare it to our required return.

To calculate YTM, we can use a financial calculator or Excel's RATE function:

N = 10 (years to maturity)
PV = -800 (price of the bond, negative because it's a cash outflow)
PMT = 100 (annual coupon payment, 10% of R1,000 par value)
FV = 1000 (par value)
Solve for i, the YTM:

i = 15.33%

Since the YTM of 15.33% is higher than our required return of 12%, we should make the purchase. This is because we are buying the bond at a discount (R800 instead of R1,000), which means we will earn both interest income and capital gains when we receive the par value at maturity. Even though the coupon rate is lower than our required return, the discounted price of the bond provides a higher yield to maturity.

You Have Just Noticed in the Financial Pages of the Local