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

Question

Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 20-year life when issued and the annual interest payment was then 13 percent. This return was in line with the required returns by bondholders at that point as described below:      

Real rate of return 4 %   

Inflation premium 5   

Risk premium 4         

Total return 13 %   

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 bonds have 15 years remaining until maturity.

Compute the new price of the bond. New price of the bond $

Explanation / Answer

New YTM =

Real rate of return+

Inflation premium +

Risk premium = 4+3+4 = 11%

K = N          
BOND PRICE= [(Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N
k=1

K = 15   
BOND PRICE= [(13*1000/100)/(1 + 11/100)^k]     +   1000/(1 + 11/100)^15
k=1

  = 1143.817

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