Karry Varcoe works as a drug manufacturer’s representative based in Newton, Iowa. She has an aggressive investment philosophy and believes that interest rates will drop over the next year or two because of an expected economic slowdown.

Karry, who is in the 25 percent marginal tax rate, wants to profi t in the bond market by buying and selling during the next several months. She has asked your advice on how to invest her $15,000.

(a) If Karry buys corporate or municipal bonds, what rating should her selections have? Why?

(b) Karry has a choice between two $1000 bonds: a corporate bond with a coupon rate of 5.1 percent and a municipal bond with a coupon rate of 3.2 percent.

Which bond provides the better after-tax return? (Hint:

See Equation [4.1] on page 130.)

(c) If Karry buys fi fteen 30-year, $1000 corporate bonds with a 5.1 percent coupon rate for $960 each, what is her current yield? (Hint: Use Equation [4.5].)

(d) If market interest rates for comparable corporate bonds drop 1 percent over the next 12 months (from 5.1 percent to 4.1 percent), what will be the approximate selling price of Karry’s corporate bonds in (c)? (Hint:

Use the Garman/Forgue companion website.)

(e) Assuming market interest rates drop 1 percent in 12 months, how much is Karry’s capital gain on the

$15,000 investment if she sells? How much was her current return for the two semiannual interest payments?

How much was her total return, both in dollars and as an annual yield? (Ignore transaction costs.)

(f ) If Karry is wrong in her projections and interest rates go up 1 percent over the year, what would be the probable selling price of her corporate bonds? (Hint: Use the Garman/Forgue companion website.) Explain why you would advise her to sell or not to sell