Question

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 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. 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.)

Answer 1

								at Rm = 9%
at t=0 to t=4	Face Value (F)= 1000						Year	Present Value Disc Factor
	Rate (%) (R ) = 12%						1	0.917431
							2	0.84168
Since the R is the same as the market rate of return hence the bond will trade at par i.e. 1000 till t=4.							3	0.772183
							4	0.708425
now at t=5	the market rate (RM) is lower by 3 % i.e. inflation is declied by 3%						5	0.649931
	hence new market rate will be 12-3 = 9%						6	0.596267
							7	0.547034
	Since RM is lower than R hence the bond will trade at premium						8	0.501866
							9	0.460428
The price of the bond =							10	0.422411
							11	0.387533
	1000 x Present Value Discouting Factor at t=25 at RM= 9%						12	0.355535
+	120 x Present Value Annuity Factor for 25 years at RM =9%						13	0.326179
							14	0.299246
							15	0.274538
=	1000 x 0.115968						16	0.25187
+	120x 9.82258						17	0.231073
							18	0.211994
=	1294.678						19	0.19449
							20	0.178431
							21	0.163698
							22	0.150182
							23	0.137781
							24	0.126405
							25	0.115968
					Present Value Annuity Factor			9.82258