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Chapter 4: Q10-15BP (page 323)

Media Bias Inc. issued bonds 10 years ago at $1,000 per bond. These bonds had a 40-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 in time as described next:

Real rate of return ........................ 2%

Inflation premium ......................... 5

Risk premium .............................. 5

Total return ............................... 12%

Assume that 10 years later, due to good publicity, the risk premium is now 2 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 30 years remaining until maturity. Compute the new price of the bond.

Short Answer

Expert verified

The new price of the bond is $1,307.88 ($75+$1,232.88).

Step by step solution

01

Computing current required rate of return-

Currentrequiredrateofreturn=Realrateofreturn+Inflationpremium+Riskpremium=2%+5%+2%=9%

02

Computing coupon amount-

Bond'scoupon=Facevalue脳Interestrate=$1,000脳12%=$120

03

Computing present value of principal where n=30; i= 9%-

Presentvalueofprincipal=Facevalue脳Presentvalueofi=$1,000脳0.75=$75

04

Computing present value of interest where n=30; i= 9%--

Presentvalueofinterest=Coupon脳Presentvalueofi=$120脳10.274=$1,232.88

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Most popular questions from this chapter

King鈥檚 Department Store is contemplating the purchase of a new machine for \(22,802. The machine will provide \)3,500 per year in cash flow for nine years. King鈥檚 has a cost of capital of 10 percent. Using the internal rate of return method, evaluate this project and indicate whether it should be undertaken.

The Clearinghouse Sweepstakes has just informed you that you have won \(1 million. The amount is to be paid out at the rate of \)20,000 a year for the next 50 years. With a discount rate of 10 percent, what is the present value of your winnings?

The Woodruff Corporation purchased a piece of equipment three years ago for \(230,000. It has an asset depreciation range (ADR) midpoint of eight years. The old equipment can be sold for \)90,000.

A new piece of equipment can be purchased for \(320,000. It also has an ADR of eight years.

Assume the old and new equipment would provide the following operating gains (or losses) over the next six years:

Year New Equipment Old Equipment

1 .................... \)80,000 $25,000

2 .................... 76,000 16,000

3 .................... 70,000 9,000

4 .................... 60,000 8,000

5 .................... 50,000 6,000

6 .................... 45,000 (7,000)

The firm has a 36 percent tax rate and a 9 percent cost of capital. Should the new equipment be purchased to replace the old equipment?

The Pan American Bottling Co. is considering the purchase of a new machine that would increase the speed of bottling and save money. The net cost of this machine is \(60,000. The annual cash flows have the following projections:

Year

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1

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2

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5

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b. What is the internal rate of return?

c. Should the project be accepted? Why?

Debby鈥檚 Dance Studios is considering the purchase of new sound equipment that will enhance the popularity of its aerobics dancing. The equipment will cost \(27,900. Debby is not sure how many members the new equipment will attract, but she estimates that her increased annual cash flows for each of the next five years will have the following probability distribution. Debby鈥檚 cost of capital is 15 percent.

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5,550 ........................ 0.3

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a. What is the expected value of the cash flow? The value you compute will apply to each of the five years.

b. What is the expected net present value?

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