Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bond

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 14 percent. This return was in ine with the required returns by bondholders at that point as described below: Real rate of return Inflation premium Riskpremium 5% 4 Total return 14% 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 ns. Round your final answer to 2 decimal places. Assume interest payments are annualy New price of the bond

Explanation / Answer

Appendix B and Appendix D for the above question has not been given.

Assuming that the bond price remain unchanges after 5 years,

Real rate of return - 5%

Inflation premium - 4%

Risk Premium - 5%

So, for determing present value of bond, we use this formula = PV at time T = expected cash flows in period T / (1 + I) to the T power

Thus, expected cash flow for the first five years @ 14%

Year 1 = $13

Year 2 = $13

Year 3 = $13

Year 4 = $13

Year 5 = $1,013

PV of the cash flows =

Year 1 = $13/(1.13)^1 = 11.50

Year 2 = $13/(1.13)^2 = 10.18

Year 3 = $13/(1.13)^3 = 9.01

Year 4 = $13/(1.13)^4 = 7.97

Year 5 = $1,013/(1.13)^5 = 549.81

Thus, Present Value of the Bond = $(11.50+10.18+9.01+7.97+549.81) = $588.47

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