Question 1
- The formula for bond calculation is as follows
The present value of the bond (price) = c x F x {1-(1+r) ^-t}/r + F/ (1+r) ^t
- C represents the coupon rate of the bond that is the interest rate the bond is offering.
- F is the face value of the bond.
- R is the market interest rate or the benchmark rate.
- T represents the number of times the interest payment is to be made.
- Since the interest is paid semi-annually the bond interest rate per period is 2.75% (5.5 / 2) the market interest rate will be 3% (6%/2) and the number of periods are 20 (2x10). Hence the price of the bond, calculated as the present value of the future cash flows will be as follows
The present value of all future cash flows (price) = c x F x {1-(1+r) ^-t}/r + F/ (1+r) ^t
Putting values in the formula we get this equation
= 2.75% x $10,000 x {1-(1+3%} ^-20}/3% + 10,000 / (1 + 3%) ^20
= $9626
Question 2
As the prime minister wants to settle the outstanding bonds each are going to be due shortly, so first of all the new issue should be long term bonds otherwise same issue will come up in near future. As the semiannual interest rate on US treasury is 4.25% which is the risk free rate of return the new issue should be much higher than this rate because it is going to be a long term bond and coupon rate increases as maturity increases and secondly, the present economic position of the country indicates high financial risk so coupon should be high enough to balance the risk factor so that investor who are willing to take risk buy the new issue. Government should manage their cash flow in the earned time, so that when maturity comes government is in position to settle the issued bonds.
Question 3
Municipal Bonds: These bonds are issued by the state or municipal authorities to finance the expenditures of government on developmental purposes like road construction, education or health services. These bonds are exempt from federal taxes and duties
Underwriting: It is an arrangement by large financial service providers for bearing the risk in IPOs. The bank or service provider ensures the client .i.e. The company that the bank will purchase the unsubscribed shares.
Bond Rating Agencies: The agencies that assess the risk and credit worthiness associated with the bonds. These companies use different letters to give a rating to the issuers of bonds on the basis of risk and their financial position. Three largest bond rating agencies are “Fitch”, “Moody’s” and “Standard and Poor’s”
Question 4
The use of medium-term budget framework in budget process helps to enhance the purposes of this budgeting process.
Fiscal Discipline and Control
MTBF allows the government to gain more control over the expenditures and creates a fiscal discipline. The linkage of fiscal resources with the outcomes and priorities increases the effectiveness and efficiency. The government is able to improve the planning process by incorporating MTBF techniques in the process. Planning incorporates more careful and detailed analysis of resources, expertise and time at hand. The resource planning is done more accurately and realistically. In this way expenditure management becomes easy and the state becomes able to cut short the expenses. Hence overall economy becomes performance based instead of expenditure based.
Alignment with Strategic Priorities
The government is able to channel its resources more efficiently to the key priorities of the state by using MTBF. This framework creates a transparency is the resources allocated for the activities, outcomes of these activities and the input resources. The service delivery is measured over the shorter period of time. The scrutiny of resource allocation through budget process is ensured by this framework. This framework involves planning commissions, economic institutions, relevant finance departments of state, legislative houses and all other stakeholders in the process of this scrutiny of resources. In this government allocates resources to top priorities and needs over short period of time.
Efficient Implementation of Budget
Question 5
- If the interest rate rises the OECD as whole will suffer because more bonds will mature (80%) in the USA and investors will be able to redeem their money from old bonds and invest in newly issued bonds which will be having high interest rates.
- The treasurer is expecting a rise in interest rate in near to medium term. The treasurer is lengthening the period so he can enjoy lower interest rate for a longer period of time
- It indicates the inflation will remain the same in the future otherwise long term bond investor will demand a higher interest rate to cover the inflation risk.
Question 6
There are certain advantages and disadvantages of financing provided by federal funds, to state for developmental purposes. Firstly, the cost of getting finance is lower for state as compared to cost associated with issuance of bonds. This is an advantage to the state. Secondly, the state gets funds for developmental purposes without much hassle. Thirdly, the risk of default by state is less; therefore, the bank is secure at all times.
The disadvantages are that the state is paying less interest payments to the federal funds. This is disadvantage for federal funds. The state has to make periodic interest payments for a decided period of time
Question 7
- Using the present value formula the present value of all future cash flow of 2million for the year is calculated as $22,939,842.44. The formula for present value is as follows
PV= Cash Flow/ (1+interest rate) ^ t
T is the year in which the cash flow is discounted. The present value formula is applied to 20 cash flows in different years and the above value is obtained.
- The treasurer should opt the second option as the present value of 20 cash flows is higher than the 20million today.
