Tom and Sue’s Flowers, Inc.’s, 15-year bonds are currently yielding a return of

Question

Tom and Sue’s Flowers, Inc.’s, 15-year bonds are currently yielding a return of 8.25 percent. The expected inflation premium is 2.25 percent annually and the real risk-free rate is expected to be 3.50 percent annually over the next 15 years. The default risk premium on Tom and Sue’s Flowers’ bonds is 0.80 percent. The maturity risk premium is 0.75 percent on 5-year securities and increases by 0.04 percent for each additional year to maturity. Calculate the liquidity risk premium on Tom and Sue’s Flowers, lnc.’s, 15-year bonds.

Explanation / Answer

8.25% = 2.25% + 3.50% + 0.80 + LRP + (0.75% + (0.04% x 10))

LRP = 8.25% - (2.25% + 3.50% + 0.80% + (0.75% + (0.04% x 10))) = 0.55%

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