Question

You are considering buying a bond that matures in one year. The current market price is $839.00. Par value is $1000. The coupon is 8%. Assuming the company does not default and pays off the bond at maturity, what would be your total return on the bond if you purchased it today at $839.00?

a. 22.45% b. 24.58% c. 28.73% d. 31.33%

Answer 1

Solution :

Calculation of value of the bond at maturity i.e., one year from now :

The formula for calculating the value of the bond at maturity is

= Par value of the bond + Total Interest earned on the bond

As per the information given in the question we have

Par value of the bond = $ 1,000 ; Coupon Rate / Interest rate = 8 % = 0.08 ; Years to maturity = 1 years

Thus Total Interest earned on the bond = Par value of the bond * Coupon Rate * Years to maturity

= $ 1,000 * 0.08 * 1

= $ 80

Total Interest earned on the bond = $ 80

Thus the value of the bond at maturity = $ 1,000 + $ 80 = $ 1,080

Calculation of total return on the bond if you purchased it today at $839.00 :

The formula for calculating the total return on the bond is

= ( Value at maturity – Purchase price ) / Purchase price

As per the information given in the question we have

Value at maturity = $ 1,080 ; Purchase price = $ 839

Applying the above information in the formula we have

= ( $ 1,080 - $ 839 ) / $ 839

= $ 241 / $ 839

= 0.28725

= 28.725 %

= 28.73 % ( when rounded off to two decimal places )

Thus the total return on the bond = 28.73 %

The solution is option c. 28.73 %