Media Bias Inc. issued bonds 10 years agao at #1,000 per bond. These bonds has a
ID: 2771858 • Letter: M
Question
Media Bias Inc. issued bonds 10 years agao at #1,000 per bond. These bonds has a 40-year life when issued and the annual interest payment was then 12%. This return was in line with the required returns by bondholders at that point in time as described next:
Assume that 10 years later, due to good publicity, the risk premium is now 2% and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 30 years remaining until maturity. Compute the new price of the bond.
Real rate of return 2% Inflation premium 5% Risk premium 5% Total return 12%Explanation / Answer
- New required return = 2 + 5 + 2 = 9%
- Price of the bond is the present value of the future cash flows discounted at the required return. Thus, price of the bond would be:
Price of the Bond = 120 x PVAF(9%, 30years) + 1,000 x PVF(9%, 30years) = (120 x 10.274) + (1,000 x 0.075) = $1,308.21