Question 4

Gustavo Fring, a seasoned businessman, has a lot of liquidity (cash) at his disposal. Accordingly, he

decides to invest some of his earnings in a fixed income security. He has two Bonds to choose

from. Each has a maturity of 5 years, a par value of $500, and a yield to maturity of 15%. Bond

A has a coupon interest rate of 5% paid annually. Bond B has a coupon interest rate of 10% paid

annually.

a. Calculate the price of both the bonds.

b. Gustavo will be investing 10,000 USD. Approximately how many of each of the two

bonds could Gustavo purchase?

c. Calculate the yearly interest income of each bond based on its coupon rate and the

number of bonds that Gustavo could buy with his $10,000.

d. Assume that Gustavo will reinvest the interest payments as they are paid (at the end of

each year) and that his rate of return on the reinvestment is only 8%. For each bond,

calculate the value of the principal payment plus the value of Gustavos reinvestment

account at the end of the 5 years.

e. Why are the two values calculated in part d different? If Gustavo were worried that he

would earn less than the 15% yield to maturity on the reinvested interest payments, which

of these two bonds would be a better choice?