Question

Last year, you purchased a 20-year bond from a snack food company -- let's call it Couch Potato -- with a face value of $1000 and an interest rate of 6% per year. This year, new bonds sold by other snack food companies with similar risk characteristics to Couch Potato are currently offering 8% interest per year. What will be the approximate value at which you could sell your Couch Potato bond today? (This is a concept question; you should be able to estimate the answer without doing the exact calculation.)

$500

$750

$1000

$1250

$1500

Answer 1

If we go conceptually, the cost of debt should be such that you get same interest in $ terms even after rate increase or decrease. Here the rate has increased from 6% to 8%, so as we know there is an inverse relationship between price and rate, the price will go down. Now formula that we use for solving conceptually this problem is :

COST OF DEBT = kd = INTEREST/PRICE

kd = 8%, INTEREST = 1000 X 6% = 60

SO kd = INTEREST/PRICE

SO 8% = 60/ PRICE

PRICE = 60/8% = 750

APPROXIMATE VALUE = 750

As i said = interest = 1000 x 6% = 60

and after rate increase = interest = 750 x 8 % = 60, you are getting same interest

ANSWER : $750 (Thumbs up please)