Question

Wilson Oil Company issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 14 percent. This return was in line with the required returns by bondholders at that point in time as described below: Real rate of return 7 % Inflation premium 3 Risk premium 4 Total return 14 % Assume that 10 years later, due to bad publicity, the risk premium is now 6 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 15 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. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)

Answer #1

Step 1 - Calculate New Required Rate of Return (Yield To Maturity).

Real rate of return = 7 %, Inflation premium = 3% , Risk premium = 6%

Total required return = 16% ( adding above 3 values)

Step 2 - Use this new required return to find the new adjusted price of the bond.

Present Value of Interest Payments

PV_{A} = A × PV_{IFA}(n = 15, i =
16%) using Appendix D ( for PVF of Annuity )

PV_{A} = $140 × 5.575 = $ 780.50

Present Value of Principal Payment at Maturity

PV = FV × PV_{IF} (n = 15, i =
16%) using Appendix B (for PVF of
Lump Sum Payment)

PV = $1,000 × .108 = $ 108.00

New Bond Price = $ 780.50 + $ 108.00 = $ 888.50

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8
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Inflation premium
4
Risk premium
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Total return
16
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Assume that 10 years later, due to bad publicity, the risk premium
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