Tom Cruise Lines, Inc., issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then
12 percent. This return was in line with the required returns by bondholders at that point as described below:
Real rate of return…. 4%
Inflation premium…. 5
Risk premium………. 3
Total return……….. 12%
Assume that five years later the inflation premium is only 2 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds.
The bonds have 25 years remaining until maturity. Compute the new price of
the bond.
New price of the bond is :$ 12194.71
Working notes for the above answer is as under
Tom Cruise Lines, Inc.
First compute the new required rate of return (yield to maturity).
Real rate of return 4%
Inflation premium 2
Risk premium 3
Total return 9%
Then use this value to find the price of the bond.
Present Value of Interest Payments
PVA = A × PVIFA (n = 25, i = 9%)
PVA = $120 × 9.82258
= $1,178.71
Present Value of Principal Payment at Maturity
PV = FV × PVIF (n = 25, i = 9%)
PV = $1,000 × .116
= $116
Particular
Amount in $
PV of Principal Payment at Maturity
1178.71
PV of Interest Payments
116
New Price of the Bond
1294.71
