Question

Lance Whittingham IV specializes in buying deep discount bonds. These represent bonds that are trading at well below par value. He has his eye on a bond issued by the Leisure Time Corporation. The $1,000 par value bond pays 5 percent annual interest and has 14 years remaining to maturity. The current yield to maturity on similar bonds is 14 percent. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

a. What is the current price of the bonds? (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)

b. By what percent will the price of the bonds increase between now and maturity?

Answer 1

Bond valuation is the determination of the fair price of a bond. As with any security or capita investment, the expected value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.

Using financial calculator:

FV = 1000

PMT = 50

N = 14

i/y = 14

Compute PV we get 459.81

Value of bond is 459.81

We know that the prices of the bond moves along the constant yield trajectory line. At maturity bond will trade at par. Hence prices would increase from 459.81 to 1000 in 14 years. Percent increase = (1000 / 459.81 - 1) = 117%

Prices of the bond would increase by 117.01% from 459.81 to 1000