Question

How much would you pay for a perpetual bond that pays an annual coupon of $50 per year and yields on competing instruments are 5 %?

You would pay $1000.

If competing yields are expected to change to 15 %, what is your expected capital gain (or loss)?

Answer 1

Calculate value of perpetual bond when yield is 5% as follows:

Bond value = Coupon / yield

= $50/5%

= $1,000

----------------------------------------------------------------------------------

Calculate value of perpetual bond when yield is 15% as follows:

Bond value = Coupon / yield

= $50/15%

= $333.33

----------------------------------------------------------------------------------

Calculate the capital gain or (loss) as follows:

Gain or (Loss) = Bond value at 15% - Bond value at 5%

= $333.33 - $1,000

= ($666.67)

Therefore, capital loss is ($666.67).