Wednesday, July 31, 2013

Valuation of Bonds

Bonds generally provide for periodic fixed interest payments at a contract rate of interest. At issuance, or thereafter, the market rate of interest for the particular type of bond may be above, the same, or below the contract rate. If the market rate exceeds the contract rate, the book value will be less than the maturity value.  The difference (discount) will make up for the contract rate being below the market rate.
Conversely, when the contract rate exceeds the market rate, the bond will sell for more than maturity value to bring the effective rate to the market rate.  This difference (premium) will make up for the contract rate being above the market rate.  When the contract rate equals the market rate, the bond will sell for the maturity value.

The market value of a bond is equal to the maturity value and interest payments discounted to the present.  Finally, when solving bond problems, candidates must be careful when determining the number of months to use in the calculation of interest and discount/premium amortization.  For example, candidates frequently look at a bond issue with an interest date of September 1 and count 3 months to December 31. This error is easy to make because candidates focus only on the fact that September is the ninth month instead of also noting whether the date is at the beginning or end of the month.

The issue price of bonds is equal to the present value (PV) of the maturity value plus the PV of the interest annuity.  The PV must be computed using the yield rate.  The computation is

Amount   PV Factor   PV
$1,000,000 × .386 = $386,000
80,000 × 6.145 = 491,600
Total issue price       $877,600

The interest amount above ($80,000) is the principal ($1,000,000) times the stated rate (8%).
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Monday, July 29, 2013

A client wants to know how many years it would take before..

the accumulated cash flows from an investment exceed the initial investment, without taking the time value  of money into account. Which of the following financial models should be used?

  • Net present value
  • Time value of money
  • Payback period
  • Internal rate of return

Answer: Payback Period

The requirement is to identify the term that describes a method that measures the number of years it takes to recoup an initial investment without considering the time value of money. This answer is correct because the definition describes the payback period.

Under Frost free conditions

The requirement is to determine what the probability of frost must be for Ball to be indifferent to spending $20,000 for frost protection.  In other words, you must find the point at which the cost of the frost protection equals the expected value of the loss from frost damage.  The table below summarizes the possible outcomes.

Market value
Market value
Market value
Market value

The difference between the market value of protected and unprotected strawberries if a frost were to occur is $100,000.  Since we want to determine the probability of a frost when the expected value of the loss from frost damage is $20,000, this probability can be calculated as follows:

Loss from
of frost
=Expected value
of the loss
  P=          .200

Thursday, July 11, 2013

What is process reengineering?

Process Reengineering is a critical evaluation and major resign of existing processes to achieve breakthrough improvements in performance.