December 2011 Question 3

The market value of a bond is always the present value of the future expected receipts (interest and repayment) discounted at the investors required rate of return.

In the case of bond (i), we know the interest (the coupon rate is 5%) and we can estimate the required returns from the table given in the question and so we get the market value by discounting at the relevant returns. Having calculated what investors would be prepared to pay – this will have to be the issue price if there is to be full take up.

In the case of bond (ii), things are a little more tricky. This time instead of us having to calculate the issue price (as above) we are told that the issue price is to be $100. Using the same logic as above, the $100 will have to be the present value of the future receipts. Since for bond (i) the issue price turned out to be $95.72 when the coupon rate was 5%, the only way people will pay $100 for a bond is if we offer a higher coupon rate. So this time we have to work backwards (like IRR) to find out what coupon rate will end up giving a present value of $100.

Understand the requirements is often a problem, and the only way to get used to this is by keep practicing past questions.

In this question, having see that you are required to consider the financial implications of the two bonds, reading about both bonds together is what gives the clue. One is to be issued at whatever price will mean investors buy it – so we need to calculate this price. The other is to be issued at $100, and so we need to calculate what the coupon rate would need to be in order for investors to be prepared to pay $100 for it.