Cuttner & Lane Corporation issues a 20-year bond with a coupon rate of 4%. Suppo

Question

Cuttner & Lane Corporation issues a 20-year bond with a coupon rate of 4%. Suppose, that the inflation rate over the period is 5%. In 20 years, Cuttner & Lane will because:

a. Inflation increases the real value of the coupon payments by the same amount as it decreases the value of the principle payment

b. Inflation decreases the real value of the coupon payments and the principle

c. Inflation increases the real value of the coupon payments, whereas the value of the principle does not change

d. Inflation increases the real value of the coupon payments and the principle

Ceteris paribus, which of the following follows from the situation described in the previous question?

a. Both borrowers and lenders are worse off because the coupon rate on a bond and the face value of a bond do not change.

b. Generally, borrowers benefit from the fact that neither the coupon rate on a bond nor the face value of a bond change over the life of the bond.

c. Generally, the lenders benefit from the fact that neither the coupon rate on a bond nor the face value of a bond change over the life of the bond.

d. Both borrowers and lenders are better off because the coupon rate on a bond and the face value of a bond do not change.

Explanation / Answer

answerof 1st question is b.

Inflation decreases the real value of both coupon and principal. With increasing inflation the constant value of coupon and principal will be worth less because their purchasing power will decrese.

Answer of second question is a.

Inflation leaves both borrower and lender worse off. Lender will receive a constant amount of money but its real value would have decresed thus resulting in real loss. All other things remaining constant such as borrowers income amount, he will be worse off because with rising inflation his contant source of income wont be sufficient to pay th coupons.

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