Question

Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 20-year life when issued and the annual interest payment was then 13 percent. This return was in line with the required returns by bondholders at that point as described below:

Real rate of return 3 %

Inflation premium 5

Risk premium 5

Total return 13 %

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 15 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

	Reuired Retun on Bonds (r)
	= Real Rate of Return + New Inflation Premium + Risk Premium
	= 3% + 2% + 5%
	= 10%
	Face Value of Bond	$1,000
	Coupon Rate	13%
	Annual Coupon (C)	$130
	[Face Value*Coupon Rate=$1000*13%]
	Time Remaining to maturity in Years (t)	15
	Amount Received on Maturity (FV)	$1,000
	New Price of Bond
	= PV of all the future copupon payments + PV of FV received at the time of maturity
	= [C*[(1+r)t-1 / r(1+r)t] + FV*[1/(1+r)t]
	= [130*[(1+0.10)15-1 / 0.10(1+0.10)15] + 1000*[1/(1+0.10)15]
	= [130*[(1.10)15-1 / 0.10(1.10)15] + 1000*[1/(1.10)15]
	= [130*[4.1772481694-1 / 0.10*4.1772481694] + 1000*[1/4.1772481694]
	= [130*[3.1772481694 / 0.41772481694] + 1000*0.23939204937
	= 130*7.60607950629 + 239.39204937
	= 988.790335817 + 239.39204937
	= 1228.18238518
	= $1228.18