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OAES Assignment
Question 6-3
Suppose you believe that the economy is just entering a recession. Your firm must raise
capital immediately, and debt will be used. Should you borrow on a long-term or a
short-term basis? Why?
It will be advisable for the firm to use long-term form of financing. This is because during
recession, interest rates tend to rise. This translates to an increase in the cost of servicing the
debt. When one takes a short term loan, they might seem to pay less at the first glance
comparison to the long term debt. This is because of the yearly renewal of the debt. This will
increase interest payments which results into lowering of bond ratings thus further increasing
interest repayments.
Problem 6-3
Expected Interest Rate. The real risk-free rate is 3 percent. Inflation is expected to be 2
percent this year and 4 percent during the next 2 years. Assume that the maturity risk
premium is zero. What is the yield on 2-year Treasury securities? What is the yield on
3-year Treasury securities?
Treasury Security Yield= r
*
+ IP + MRP
Where: r
*
=3%
MRP=0
IP=(2 + 4 + 4)/3=3.3333
=3 + 3.3333 + 0= 6.3333
=6.3333%

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Problem 6-13
Default risk premium. The real risk-free rate, r*, is 2.5 percent. Inflation is expected to
average 2.8 percent a year for the next 4 years, after which time inflation is expected to
average 3.75 percent a year. Assume that there is no maturity risk premium. An 8-year
corporate bond has a yield of 8.3 percent, which includes a liquidity premium of 0.75
percent. What is its default risk premium?
Corporate bond yield=r*+ IP + MRP + DRP + LP
Where: Yield=8.3%
r*= 2.5%
IP= {(2.8 X 4)+ (3.75 X 4)}/8 = 3.275%
MRP= 0
DRP=?
LP= 0.75%
DRP=8.3 – (O.75+2.5+ 0 + 3.275)
1.775%
Problem 7-9
Yield to maturity. Heymann Company bonds have 4 years left to maturity. Interest is paid
annually, and the bonds have a $1,000 par value and a coupon rate of 9 percent.
a. What is the yield to maturity at a current market price of (1) $829 or (2) $1,104?
Using Excel MS rate function given that;
Nper=4
Pmt=9%*1000

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Fv=1000
Pv= -829 and -1104
YTM = RATE(4,90,-829,1000)= 15%
YTM = RATE(4,90,-1104,1000)= 6%
b. Would you pay $829 for each bond if you thought that a “fair” market interest rate for
such bonds was 12 percent—that is, if rd12 percent? Explain your answer.
At 12% the PV should be as follows;
Rate=12%
Nper=4
Pmt=12%*1000=120
Fv=1000
PV= $1000.
Given such valuation, I would buy the bond since it is selling at a discount i.e. below market
price.

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Anonymous
Excellent resource! Really helped me get the gist of things.

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