CORPORATE FINANCE

CORPORATE FINANCE3

CORPORATEFINANCE

Theexpected price (Ep) of a bill =1-I/D.

Where:

Iis the interest rate and

Dis the duration/ time to maturity in days.

OnTuesday 5thJanuary the interest rate =1.94% pa time=10yrs

Theprice of the bill on February 5 2015 will be approximately $ 994.456calculated as follows:

Thepar value of a bill is $ 1,000.

Usinga 360 day year in 10 years =3,600 days

Less:

36days: the days to maturity from February 5 2015 (31 days in January and 5 days in February) four days in 2015 (3,600-36)= 3,564

Dailyinterest rate= 1.94%/3,564=0.000544%

Theprice asat 5th January = 1-0.0005449 =$ 0.999456

Thenmultiply by 1000 and the price = $ 994.456

Theprice of the same bill as at January 7 2016 will be $ 999.400calculated as follows:

Usinga 360 day year in 10 years =3,600 days

Less:

367days: the days to maturity from January 7 2016 (360 days for 2015 and7 days in 2016 January) (3,600-367) = 3,233 days

Dailyinterest rate= 1.94%/3,233 = 0.000600%

Theprice as at 7thFebruary 2016 = 1-000600=$ 0.999400

Thenmultiply by 1000 and the price = $ 999.400

Theexpected prices on bonds may change due to a variety of reasons. Theyare determined by demand and supply conditions existing at any pointin time. (Ross et al. 2013, p. 222)

First,the prices may change due to inflation expectations held by theinvestors. The major inflation cause in the United States is theincrease in wages and salaries (Eavis 2015, p. 2). According to Rosset al. (2013, p. 223), if the employees expect higher wages andanticipate consumption through loans. The increased wages cause anincrease in the wage costs incurred by corporations and if thecompanies prefer to meet the increased wage costs by borrowinginstead of increasing their sales, there is an increase in demand forloans. Increased demand for loans makes interest rates to rise. Inaddition, when investors expect that there is going to be highinflation, they expect to be compensated with higher interest ratesfrom bonds due to the loss of their money. After they demand higherinterest rates, the expected prices of bonds will fall since theexpected prices on the bonds are inversely related to the interestrates. The inverse will occur when there is a low inflationexpectation among the investors (Ross et al. 2013, p. 223).

Secondis wealth. Wealth will lower the interest rates and raise the prices.When there are many wealthy investors willing to invest in bonds, thedemand for bonds, rise causing the expected price to increase whilethe interest rates will fall due to the inverse relationship.Further, if a country is poor it will encounter deficits in itsbudget and result into borrowing, increased demand will causeinterest rates to rise. The government will cause a crowd out effectwhere the corporate will be unable to borrow due to the high interestrates (Ross et al. 2013, p. 225).

Third,the expected price of bonds will fluctuate due to the regular andirregular influences of the central banks. When money is inoversupply, the central bank will sell government bonds and henceabsorbing the extra money in the economy. As a result of the reducedamount of money in the economy, the demand for bond is reducedcausing a fall in prices while the interest rates rise (Ross et al.2013, p. 225).

Bibliography

Eavis,P 2015, ‘Soaring Bond Prices May Sound an Economic Warning’, TheNew York Times 7January. Available from:&lthttp://dealbook.nytimes.com/2015/01/06/soaring-bond-prices-may-sound-an-economic-warning/?_r=0&gt.[17 January 2015].

ROSS,S. A., WESTERFIELD, R., &amp JORDAN, B. D. (2013). Fundamentalsof corporate finance.New York, NY, McGraw-Hill/Irwin.