Question

Wilson Oil Company issued bonds five years ago at $1,000 per bond. These bonds had a 30-year life when issued and the annual interest payment was then 13 percent. This return was in line with the required returns by bondholders at that point in time as described below: Real rate of return 5 % Inflation premium 4 Risk premium 4 Total return 13 % Assume that 10 years later, due to bad publicity, the risk premium is now 7 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years remaining until maturity. Compute the new price of the bond. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

Answer 1

Price of a bond is mathematically calculated using the formula:

where P is price of bond, with periodic coupon C, maturity value M, YTM i and n periods to maturity

For this question, the new YTM = 5% + 4% + 7% = 16%

M = $1000, C = $130, n = 20

P = 770.75 + 51.39

P = $822.13

For calculator, use the inpits:

i/Y = 16%, N = 20, PMT = 130, FV = $1000. CPT PV. PV = -$822.13 (Remember negative sign indicate opposite in direction as compared to the coupon and maturity value. This means, you need to pay this price to receive the coupon and maturity value)