Problem 10-13 Effect of yield to maturity on bond price [LO3] Tom Cruise Lines I
ID: 2721011 • Letter: P
Question
Problem 10-13 Effect of yield to maturity on bond price [LO3]
Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 30-year life when issued and the annual interest payment was then 15 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 bonds have 25 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.)
References
Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 30-year life when issued and the annual interest payment was then 15 percent. This return was in line with the required returns by bondholders at that point as described below:
Explanation / Answer
First compute the new required rate of return (yield to maturity).
Real rate of return 5%
Inflation premium 3
Risk premium 5
Total return 13%
Then use this value to find the price of the bond.
Present Value of Interest Payments
PVA = A × PVIFA (n = 25, i = 13%) Appendix D
PVA = $150 × 7.330 = $1,099.5
Present Value of Principal Payment at Maturity
PV = FV × PVIF (n = 25, i = 13%) Appendix B
PV = $1,000 × .047= $47
$1,099.50
47.00
$1,146.50
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