A corporation has an obligation to pay 100, 000 at the end of two years and another 100, 000 at the end of three years. There are two bonds available to buy and try to match these liabilities. The first bond is a two-year bond with annual coupons at rate 20%, and the second bond is a three-year bondwith annual coupons at 40%. The yield rates on both bonds and reinvestment rates for each of thenext three years are all at an annual effective rate of 25%. The corporation purchases α face amountof the two-year bond and β face amount of the three-year bond. The coupon received at time oneis reinvested, and any excess of bond payment over 100, 000 at time 2 is reinvested. The reinvestedamount along with the bond payments at time three are exactly enough to pay the 100, 000 due attime three. Find the minimum value of α that will guarantee that the asset cashflow available at time two is at least 100, 000. Show your work.

Intermediate Accounting: Reporting And Analysis
3rd Edition
ISBN:9781337788281
Author:James M. Wahlen, Jefferson P. Jones, Donald Pagach
Publisher:James M. Wahlen, Jefferson P. Jones, Donald Pagach
Chapter14: Financing Liabilities: Bonds And Long-term Notes Payable
Section: Chapter Questions
Problem 5MC
Question

A corporation has an obligation to pay 100, 000 at the end of two years and another 100, 000 at the end of three years. There are two bonds available to buy and try to match these liabilities. The first bond is a two-year bond with annual coupons at rate 20%, and the second bond is a three-year bond
with annual coupons at 40%. The yield rates on both bonds and reinvestment rates for each of the
next three years are all at an annual effective rate of 25%. The corporation purchases α face amount
of the two-year bond and β face amount of the three-year bond. The coupon received at time one
is reinvested, and any excess of bond payment over 100, 000 at time 2 is reinvested. The reinvested
amount along with the bond payments at time three are exactly enough to pay the 100, 000 due at
time three. Find the minimum value of α that will guarantee that the asset cashflow available at time two is at least 100, 000. Show your work.

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