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

Question

Tom Cruise Lines issue bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was 12%. This return was in line with the required returns by bondholders at the point as described below

real rate of return 3%
inflation premium 4%
risk premium 5%

total return 12%

Assume that five years later the inflation premium is only 3% and is appropriately reflected in the require return or yield to maturity of the bonds. The bonds have 20 years remaining until maturity.

New price of the bond?

Explanation / Answer

Current yeild to maturity= Real rate of return+inflation premium+Risk premium

                                   =3%+4%+5%=12%

New price of bond={A*[(1-[1/(1+i)^n)]/i]}+[Fv*(1+i)^n]

                          ={(0.12*1000)*[(1-1/1.12)^20)]/0.12]+1000*(1.12)^20

                            =(120*8.514)+(1000*0.149)

                           =$1170.686

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