Doug has been approached by his broker to purchase a $1,000 bond for $795. He believes the bond should yield 8%. The bond pays a 5% annual coupon rate and has 10 years left until maturity. What should Doug's analysis of the bond indicate to him? Use annual analysis.
A) The bond is undervalued; he should purchase it.
B) The bond is undervalued; he should not purchase it.
C) The bond is overvalued; he should purchase it.
D) The bond is overvalued; he should not purchase it.

Question

Quizplus · Accepted Answer

To determine whether the bond is undervalued or overvalued, we need to calculate its yield to maturity (YTM) and compare it to Doug's required yield of 8%.

Using the bond's current price and its future cash flows (the $50 annual coupon payments and the $1,000 principal repayment at maturity), we can calculate a YTM of approximately 8.06%. This is slightly higher than Doug's required yield, indicating that the bond is undervalued.

Therefore, Doug should purchase the bond at the offered price of $795, as it is trading at a discount to its fair value and will provide him with a yield slightly higher than his required rate of return.

Doug Has Been Approached by His Broker to Purchase a $1,000