Question

9) MrC Corp has a bond issue outstanding that pays $70 every year for the next...

9) MrC Corp has a bond issue outstanding that pays $70 every year for the next 4 years.    It has a face value (par value) of $1,000 and will mature in four years.

Assume: real risk-free rate = 3%, inflation premium = 2%, Maturity risk premium = 1%, Default risk premium = 4%, and liquidity premium = 2%. Given these conditions, what is the value ( or price) of the bond?

a. $848

b. $905

c. $925

d. $769

e. $729

Note: I’m not sure how to solve given the assumptions. Could I have an explanation if possible?

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Answer #1

Interest rate required on the bond (YTM) is the sum of all factors of interest viz. Real risk free rate of 3%, Inflation 2%, Maturity risk premium of 1%, Default risk premium of 4% and liquidity premium of 2%.

Therefore, YTM = 3+2+1+4+2= 12%

Price of the bond is the sum of present value of future cash flows discounted at YTM.

Given, yearly interest =$70 and Face Value on redemption after 4 years=$1,000.

Current price= 70(PVIFA 12%,4) + 1000(PVIF 12%,4)

=70* 3.037349 + 1000* 0.635518 = $212.61 + $635.52 = $848.13

The answer is option (a).

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