You bought one of Great White Shark Repellant Co.’s 10 percent coupon bonds one

Question

You bought one of Great White Shark Repellant Co.’s 10 percent coupon bonds one year ago for $800. These bonds make annual payments and mature 11 years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 11 percent. If the inflation rate was 3.3 percent over the past year, what was your total real return on investment?

a) 26.88%

b) 13.50%

c) 34.02%

d) 25.60%

e) 25.70%

You bought one of Great White Shark Repellant Co.’s 10 percent coupon bonds one year ago for $800. These bonds make annual payments and mature 11 years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 11 percent. If the inflation rate was 3.3 percent over the past year, what was your total real return on investment?

Explanation / Answer

To find the real return ,we first need to find the nominal return ,which means we need the current price of the bond. Going back to the chapter on pricing bonds, we find the current price is:

P1=$100(PVIFA11%,11)+$1000(PVIF11%,11)

=100(6.2065)+1000(0.3173)

=620.65+317.3=937.95

YOUR cash flows: Sale price - purchase price + one coupon(<you received this b/c you held the bond for one year)
937.95 - 800 + 100 = 237.95
Return before accounting for inflation = net proceeds/initial investment =237.95 / 800 = 0.2974 or 29.74%
the formula for Nominal rate..(1 + Nominal) = (1+Real rate)(1+inflation rate)
solving for real return...
1.2974= (1 + Real)(1.033)

1+real=1.2974/1.033

real=1.2559-1=0.2560 or 25.60%

Ans is D.25.60

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