Question

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	3	%
Inflation premium	4
Risk premium	5
Total return	12	%

Assume that five years later the inflation premium is only 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. 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.)

New Price of bond ___________

Answer 1

The Revised Yield to Maturity of the Bond

The Revised Yield to Maturity of the Bond =   Real rate of return + Revised Inflation premium + Risk premium
= 3% + 3% + 5% = 11%

New Price of the Bond

The Price of the Bond is the Present Value of the Coupon Payments plus the Present Value of the Face Value/Par Value

The Price of the Bond is normally calculated either by using EXCEL Functions or by using Financial Calculator.

Here, the calculation of the Bond Price using a financial calculator is as follows

Variables	Financial Calculator Keys	Figures
Par Value/Face Value of Bond	FV	$ 1,000
Coupon Amount (1000 * 12%)	PMT	$ 120
Market interest rate or Yield to Maturity of the Bond	1/Y	11%
Maturity Period/Time to Maturity	N	20
Bond Price	PV	?

After entering the above keys in the financial calculator, we get the Price of the Bond (PV) = $ 1079.63

We can use Excel to find PV as well in the following way:

New price of the bond = pv(rate,nper,pmt,fv)

PV = [rate = 11%, nper = 20, PMT = -120, FV = 1,000 ]

New price of the bond = pv(11%,20,-120,1000)

= $ 1079.63