Tom Cruise Lines Inc. issued bonds five years agao at $1,000 per bond. These bon

Question

Tom Cruise Lines Inc. issued bonds five years agao at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 15%. This return was in line with the required returns by bondholders at that point as described next:

5%

Assume that five years later the inflation permium is only 3% and is approperately reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years remaining until maturity. Compute the new price of the bond.

5%

Explanation / Answer

Yield to maturity.

Real rate of return                4%

Inflation premium                6

Risk premium                     5

Total return                   15%

Price of the bond.

PV of Interest Payment

PVA = A × PVIFA (n = 20, i = 15%)                                           

PVA = $150 × 6.25933= $ 938.8997

PV of Principal Payment at Maturity

PV = FV × PVIF (n = 20, i = 15%)                                            

PV = $1,000 × 0.06110 = $ 61.100278                                   

$938.8997

61.100278

999.999 = 1000                                                                          

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