Exercises
Federica Ielasi
2010 October 6
Exercise
• What is the yield on a $1,000,000 municipal
bond with a coupon rate of 8%, paying
interest annually, versus the yield of a
$1,000,000 corporate bond with a coupon
rate of 10% paying interest annually?
• Assume that you are in the 25% tax bracket.
Sol
• Municipal bond coupon payments equal
$80,000 per year. No taxes are deducted;
therefore, the yield would equal 8%.
• The coupon payments on a corporate bond
equal $100,000 per year. But you only keep
$75,000 because you are in the 25% tax
bracket. Therefore your after-tax yield is only
7.5%
Exercise
• Consider a $1,000 bond paying a 20% annual coupon
(maturity date: year 2). The issuing company has 20%
chance of defaulting this year; in which case, the
bond would not pay anything.
• If the company survives the first year, paying the
annual coupon payment, it then has a 10% chance of
defaulting in the second year. If the company
defaults in the second year, neither the final coupon
payment nor par value of the bond will be paid.
Sol
• The expected cash flow at t1 = 0.20 (0) + 0.80
(120) = 96
• The expected cash flow at t2 = 0.25 (0) + 0.75
(1,120) = 840
• The price today should be: (96/1.10) +
(840/(1.10)^2) = 781.49