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M B004 5 –Financial Management SET1 Q.1 . Sh ow the relationship between required rate of retur n and co upon rate on the value of a bond. Ans: It is important for prospective bond buyers to kno w how t o determine the price of  a bo n d beca use it will indicate the yie l d received should the bo n d be purchased. In this section, we will run thro u gh some bo n d price calculations for various ty p es of bond instruments. Bon ds ca n be priced at a premium, discoun t, or at par. If the bonds price is higher than its par value, it will sell at a premium bec aus e its interest rate is h i gher than current prevailing rates. If the bonds price is lower than its par value, the bo n d will sell at a discoun t because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bon d, you ar e calculating the maximum price you wou ld want to pay for the bond, given the bonds coupon rate i n comparison to the average rate most investors are cur r ently recei ving i n the bo n d market. Required yie ld or required rate of return is the interest rate that a security nee ds to offer in order t o encourage investors to purchase it. U sua ll y the required yie l d on a bond is equal to or greater than the current prevai ling i nterest rates. Fun damentally, however, the price of a bond is the sum of the presen t values of all ex p ected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is dis c ou nting the kn o wn f uture cash flows. Remember that to calculate prese nt value (PV) – which is based on the ass umption that each payment is re-invested at some interest rate on ce it is receivedwe have t o kn ow the interest rate that would ea rn us a kno wn f uture value. For bo nd pric i ng, this interest rate is the required yie l d. (If the co n cep t s of  present and future value are new to you or you are unfami liar with t he calculations, ref er t o Understa n ding the Time Value of Money.)

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