Effect of yield to maturity on bond price (LO3) Tom Cruise Lines, Inc., issued b

Question

Effect of yield to maturity on bond price (LO3) 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 5 Risk premium 4 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.

Explanation / Answer

Tom Cruise Lines, Inc. First compute the new required rate of return (yield to maturity). Real rate of return Inflation premium Risk premium Total return 3% 3 4 10% Then use this value to find the price of the bond. Present Value of Interest Payments

PVA = A PVIFA (n = 20, i = 10%) PVA = $120 8.514 = $1,021.68

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Appendix D

Present Value of Principal Payment at Maturity PV = FV PVIF (n = 20, i = 10%)

Appendix B

PV = $1,000 .149 = $149 $1,021.68 149.00 $1,170.68

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