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 line with the required returns by bondholders at that point as described below: real rate of return 4 % inflation premium 5 risk premium 5 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

Market value of the bonds with the current change: 1,150.4630

Explanation:

if the inflation premium decrease to 3 from 5

then the YTM will decrese as well.

4 + 5 inflation + 5 maturity  = 14 bonds rate

4 + 3 inflation + 5 maturity  = 12 YTM

We will calcualte the present value of the bond at 12% discount rate:

The coupon payment will be done using the ordinary annuity formula

Coupon payment: 1,000 x 14%/2 =70

time40      (20 years x 2 payment per year)

rate          0.06  (12% divide into 2 paymetn per year)

PV$1,053.2408

Maturity   1,000.00 (face value)

time   40.00

rate  0.06

PV   97.22

now we add-up both values:

PV c1,053.2408

PV m  97.2222

Total1,150.4630

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