Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bond
ID: 2792709 • Letter: T
Question
Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 12 percent. This return was in line with the required returns by bondholders at that point as described below:
Assume that five years later the inflation premium is only 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bondss have 20 years remaining until maturity.
Compute the new price of the bond. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)
New Price of the Bond?
Real rate of return 3 % Inflation premium 4 Risk premium 5 Total return 12 %Explanation / Answer
Yield to maturity on bonds after 5 years
real rate of return+ inflation premium+ risk premium+
3+3+5
11%
value of bonds after 5 years
interest*PVAF at 11% for 20 years + par value*PVF at 11% for 20th year
120*7.963328 + 1000*.124034
1079.633
PVAF at 12% for 20 semiannual period
1-(1+r)^-n / r
1-(1.11)^-20 / .11
7.963328
PVF at 11% at 20th year
1/(1+r)^n
1/(1.11)^20
0.124034
Yield to maturity on bonds after 5 years
real rate of return+ inflation premium+ risk premium+
3+3+5
11%
value of bonds after 5 years
interest*PVAF at 11% for 20 years + par value*PVF at 11% for 20th year
120*7.963328 + 1000*.124034
1079.633
PVAF at 12% for 20 semiannual period
1-(1+r)^-n / r
1-(1.11)^-20 / .11
7.963328
PVF at 11% at 20th year
1/(1+r)^n
1/(1.11)^20
0.124034