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 10 percent.

1) What is the current price of the bonds?

2) By what percent will the price of the bonds increase between now and maturity? Price increase by __%

Answer 1

(1) Price of a bond is equal to the PV of the coupon payments and PV of the principal received on maturity. The discount factor used should be the minimum required return expected by investors, for eg, discount factor can be the YTM on similar bonds.

Current price in this case = Coupon payment p.a*annuity factor(10%,14 yrs)  + Principal amount*discount factor (10%, 14thyr)

= 50*7.367 + 1000*0.263

= $ 631.35 (approx)

(2) Percentage increase in price= (Maturity value- current value)/current value

= (1000-631.35)/631.35

= 58.39% (approx)