Kavita De Falla is an individual with low risk tolerance who has just inherited $100,000. She has no immediate needs for the funds but would like to supplement her current income. Thus, De Falla is considering investing these funds in debt instruments, since the interest and repayment of principal are legal obligations of the issuer. While she realizes that the borrower could default on the payments, she believes this is unlikely, especially if she limits her choices to triple- or double-A-rated bonds. De Falla does realize that she could earn more interest by purchasing lower-rated bonds but is not certain that she is capable of bearing the risk.
Besides the risk and expected reutrn, De Falla decides that tax considerations must also play a role in this investment decision. She is currently in the 28 percent federal income tax bracket and pays state income tax of 5 percent.
De Falla quickly learned that there are many bonds among which to choose.
Bond Interest Per $1,000 bond Coupon
A $50 5%
B $100 10%
C $100 10%
D $80 8%
Bond Term Price Yield To Maturity
A 1 year $981 7%
B 5 years $1,035 9.1%
C 10 years $1000 10.0%
D 20 years $742 11.3%
Currently, the interest rate of long term debt ranges from 9 to 11.5 percent. Help her answer the following questions:
1. a) What would be the expected price of each bond one year from now if interest rates were 8 percent?
b) What would be the expected price two years from now if interest rates initially fall but subsequently rise to 12 percent at the end of the second year?
2. If interest rates were expected to fall and not rise back to 12 percent, which alternative is best?
3. If interest rates were expected to decline initially and then rise, which alternative should be selected?
4. If bond A were selected, what would happen after a year elapses? What decision must then be made?