Question

Media Bias Inc. issued bonds 10 years ago at $1,000 per bond. These bonds had a 30-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 in time as described below:

Real rate of return 5 %

Inflation premium 4

Risk premium 4

Total return 13 %

Assume that 10 years later, due to good publicity, the risk premium is now 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years remaining until maturity. Compute the new price of the bond.

Answer 1

Real rate of return =					5%
Inflation premium =					4%
Risk premium =					3%
New required rate of return is = 5% + 4% + 3% =					12%
Years to maturity =					20 Years
Annual coupon rate =		13.00%
Annual coupon amount = 1000* 13.0% =				130
Calculation of Price of bond
Annual coupon received			130
Cumulative P.V.F. @ 12 % for 20 Years			7.469444
{ 1 / (1.12)^1 } + {1 / (1.12)^2+…..........+1/(1.12)^20 }
Present value of Coupon payments(coupon * Cum.P.V.F.)				971.0277
Maturity amount received			1000
P.V.F. @ 12 % for 20th year			0.103667
( 1/(1.12)^20 )
Present value of maturity payement(1000* 0.086782)				103.6668
				_________
Price of bond (Total present value)				1074.694
				_________
So, price of bond is $ 1074.69.