Question

National Steel's 20-year, $1,000 par value bonds pay 11 percent interest annually. The market price of the bonds is $700, and your required rate of return is 18 percent.

a. Compute the bond's expected rate of return.

b. Determine the value of the bond to you, given your required rate of return.

c. Should you purchase the bond?

Answer 1

Part-a :

Computation of Expected rate of return of a bond : Interest income of a bond + Gain on sale /20years

Average investment

= 110+(300/20)

(1000+700)/2  

= 125/850

=.0.14705

= 14.705%

Part-b

Value of a bond :

Particular	Year	Cashlow	PV /AF@18%/	Discounted cash flow
Interest	1-20	110	5.3527	588.797
Maturity Value	20	1000	0.0365	36.5
Expected Value of the bond				625.297

Part- c : Should the bond be purchased

No, We may not purchase the bond because we expect the bond price to be $625.29 (as per part-b) but the bond current market price is $700 which is more than our expectation.