Question

Assume that you have inherited a perpetual bond that pays $1000 annually.

a. If you accepted $30,000 today in exchange for the bond, what is your opportunity cost of funds?

b. Assume that the opportunity cost of funds increases to 8%, what happens to the present value of the bond?

c. Using the information in (a) and (b), why does the present value of the bond increase (decrease) when the opportunity cost of funds rises (falls) from (a) to (b)?

Answer 1

Perpetual Bond with Annual cash payment = 1000

A) PV of bond = 30000;

PV of the bond = Annual payment / rate (Opportunity Cost)

Opportunity Cost = Annual Payment / PV

= 1000/30000= 0.03333 = 3.33%

B) Now opportunity cost = 8% = 0.08

PV of bond = 1000/0.08 = 12500

C)

Present value of the bond decrease when the opportunity cost of funds rises because the demand of net return from the investment has increased and any one buying the bond would buy at a considerable lower value to get the net return (prevalent today in market) on his investment.