Question

3. Suppose a bond you hold promises to pay you $150 each year for the next...

3. Suppose a bond you hold promises to pay you $150 each year for the next five years.

(a) What type of bond are you holding?

(b) What is the present value of this bond if the market interest rate is 4% and the bond is considered riskless?

(c) If the risk premium is equal to 5%, what is the present value of this bond? Would you purchase this bond if it was offered to you for $550?

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Answer #1

Ans:

a) This is a coupon bond. coupon bonds are bearer bonds and the bond holder receives annual interest.

b) Present value of the bond is the present of future cash flow expected to arise from the bond.

Discounting factor = 1 / (1+i)^n

Present value of the bond = $150 * sum of discounting factor for year 1 to year 5@4%

= $150 * 4.4518

= $667.77

c) when risk premium is 5%, discounting rate is 9% .i.e(4%+5%)

Present value of the bond = $150 * sum of discounting factor for year 1 to year 5@9%

= $150 * 3.8896

= $583.44

Since the purchase price is less than the present value of the bond , purchasing the bond is recommended.

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